Wednesday, November 2, 2011

Time for a New Thermometer

We have a strange habit of estimating our own happiness by what other persons think it is; and their opinion is likely to be based on our material success, since they have little else to go by. We continually try to obtain the things that the people around us want or profess to want, rather than what we want ourselves, because we have never really tried to examine whether there is any difference between the two. In trying to find whether we are hot or cold, we attach more importance to a dubious thermometer than we do to our own feelings – Henry Hazlitt, The Way to Will-Power

I don’t know much about economics so I'm probably misunderstanding and misstating a lot of this stuff.  However, this is how I see what happened in Europe addressing the problem of a default by Greece. 

The Euro is a single currency – a fiat currency – backed up by the property and productivity of several European nations.  In fact, the productivity in Europe, as a whole, is rather low.  But it is very high in Germany.  The Germans build things – like cars – for export. They sell these products across Europe at a relatively stable price as long as the Euro is stable.  You don’t have the price of a Volkswagen suddenly doubling in Greece because the drachma was devalued.  But Greece, Spain, Portugal, Italy, and, to a lesser extent, Ireland are importers with mainly service and tourism-based economies.  All of these countries have vast government sectors that employ far more civil servants than are needed for healthy private sector growth.  They offer relatively lucrative pensions to government workers, allowing them to retire after twenty or twenty-five years to make way for a new generation of bureaucrats who surrender a fairly high portion of their salaries to support the retirees. 

What happens, though, when the next generation is a little smaller than the current one?  And the next a little smaller still?  Eventually, you get one worker supporting the pensions of several retirees – on a government paycheck.  Add to this the expense of drug addicts, immigrants, losers and others who become additional parasites on the host government.  At some point the government runs out of money and must borrow to continue to pay the benefits and support its workers.  Eventually this leads to greater and greater deficits as the accumulation of interest due adds to the debt.  It is analogous to the situation many have found themselves in with regard to credit card debt on which they have paid the minimum.  All they are paying is the interest on the loan, which keeps getting higher and higher over time as the principal continues to grow through taking on more debt. 

There are a couple of solutions for the individual.  Preferably a person with excess debt will realize the difficulty of the situation, reduce spending to manageable levels, perhaps increase income, and begin to pay down the principal without accumulating new debt.  If things go too far, however, the only solution may be bankruptcy.  It should be noted that while paying down debt is more or less neutral with regard to money supply, bankruptcy is deflationary.  Not only does it take money out of the system in the form of zeroing out an asset on the creditor’s balance sheet, it usually deters the debtor from adding liabilities in the near future.  And, again, I am neither accountant nor economist so my understanding may be somewhat amiss here. 

A nation can do the same thing with its debt.  They have an additional avenue in some cases, that of printing money and devaluing the currency so that debts can be more easily discharged.  When you hear about the hyperinflation that took place in the Post-WWI German Weimar Republic, you have to keep in mind that the Treaty of Versailles imposed a huge war debt upon Germany to be paid to France.  This debt prevented Germany from rebuilding, and they could not eliminate it through default so they began to print money.  At some point, things got out of hand, and people lost faith in the currency altogether. 

Conceivably, Greece and the other heavily indebted nations of Europe could do the same thing, except they are not entirely in control of their currency.  The structure of the European Monetary Union, aka the Eurozone, prevents this.  The Greek government has financed its debt by selling bonds to private citizens throughout the world and Eurozone, to other governments such as China and Germany and to banks – including central banks like the ECB.  Banks took the bonds for which they had paid good money and used them to enhance their balance sheets so they leverage more borrowing because, of course, the bonds paid interest plus they could always be sold for some percentage of face value. 

Except now everyone realizes that Greece is never going to fully honor those bonds.  They are going to quit paying interest and default which would be a significant write off of assets for the banks in particular.  So the EU folks got together and said that they are going to devalue Greek bonds by 50%.  The debt is reduced but Greece still has to pay interest on half.  Initially the Euro rose sharply on news of this development because it is deflationary.  A few billion Euros disappear, which, in and of itself, is no big deal.  There are, however, a couple of things to note.  First, the full 50% haircut is only on privately-held bonds.  Bonds held by public entities, such as other governments, e.g., China or Germany, took, I believe a 21% cut in face value – not bad when the short-term interest rate was running about 100%.  But Greek bonds held by the European Central Bank and the International Monetary Fund took no haircut at all. 

The next is that the Greeks are not all that happy about the deal.  They want the monkey off their backs and the opportunity to start fresh via default.  They would probably even like to opt out of the EMU and return to screwing things up locally with the good old drachma.  Who could blame them?  This does not make the central bankers happy because, first, Greek is not the only EMU country that has out-of-control debt, and second, Greek bonds used as security for the infamous Collateralized Debt Obligations, CDOs, in a pool along with other bonds and instruments.  The Greek bonds are a part of the CDO – you will hear it called a “tranch” or slice of the pool.  Some of the higher risk CDOs that included Greek bonds are now are risk if the devaluing of these Greek bonds is seen as a credit event.  The CDOs are part of the leveraged structure of the Euro fiat system.  A pure Greek default might not be that big a deal, but it could conceivably ripple through the EMU and cause a lot of havoc.  If Greece goes down, is Italy next?  There is insufficient real value in the system if the potential defaults start cascading.

This is what caused such ridiculous exuberance in the markets last week.  When the Greek government started talking sovereignty and a referendum, the markets reacted negatively out of fear.  Right now, things seem to be holding steady, and the US market, at least, is buoyed somewhat.  My guess is that the Greeks will go along with some sort of deal that lets them keep living, for the most part, like parasitic bums.  The trouble is that all the EMU is doing is pushing the catastrophe a few months down the road.  Much like what the Fed is doing here.

Did you ever try to push a car up a slope?  Imagine you start out with a small, light car – I pushed an ‘80’s model Sunbird up a grade one time.  It wasn’t that hard.  But let’s say that as you are pushing, someone comes along and places a lead weight in the driver’s seat then another in the passenger seat and some in the back seat then another on the hood and so forth.  With every added weight you have to fight more and more against gravity.  Where you were pushing at a mile an hour at first, now you are down to half that then a quarter then a tenth.  If they keep adding weights, you may only be able to inch the car forward.  Finally you reach a point in equilibrium with gravity where you simply cannot push the car any farther.  It is all you can do to hold the car in place on the hill as it threatens to roll violently back down.  The global economy is at or very near the point of not moving forward at all.  The weights are the public debt of multiple nations and blocks of nations, not to mention the billions in private debt, much of it, like sovereign debt, unsecured. 

Debts are not decreasing in the face of crisis but increasing.  Central banks continue to buy bonds, which is the same as printing money.  They are the ones pushing the car.   But their best efforts, as we saw here with QE2 last year, simply held things in place while adding still more weight to try and move.  At some point, in some way the crash is coming.  Do not be deceived.  The gods of the copybook headings are never mocked in the end.


  1. Hello again Mushroom. No, I'm not stalking you but found this through your other blog. It seems we have similar views about the future and what to do about it. Thanks for splainin the Greek/Euro mess. It's all gonna crash.

  2. Hey, John.

    When my now-16-yo granddaughter was about 3, I took her to a Memorial Day airshow. A couple of bright yellow planes staged a mock dogfight above us. She was sitting on my shoulders, yelling, "Dare chasin' each other! Dare gonna cwwaaash!"

    That is sure the way it looks.

    I post stuff here that I feel guilty about even thinking. But you are always welcome to stop by and view the lunacy.

  3. Hi mushroom,
    If you don't know much about economics let me tell you you have a fine insight.
    One idea I didn't get though. Why is bankruptcy deflationary? It destroys wealth, not the representation of it (cash). Shouldn't it be then inflationary?
    Great blog by the way.

  4. Thanks, Jim. I hope I can encourage you to look into some of this on your own and read other sources who are more knowledgeable than I am.

    I think I understand your point in that once a person has declared bankruptcy, they will still have some of their stuff and will have eliminated their debt so that they can now spend their income on other items -- which is true. But it will be very difficult for them to incur additional debt for some time -- probably several years. They will have to live within their means, more or less, based on their productivity and income-generating power.

    They will, in other words, create no new money based on debt. The loss the bank takes also decreases its ability to create new money via fractional reserve banking.

    Say you buy a car on credit. The bank has loaned you $20,000. They count that $20,000 promise to pay by you as an asset. On your side, you count the car as a liability as far as the amount owed is over market value. The manufacturer and the dealer have the banker's money.

    Now where did that $20,000 come from? Did it come out of the bank vault? Did they take the $20,000 Joe had deposited in the bank and use it to pay the local dealer? If they did, how is it that Joe still sees it on his statement?

    Banking is done on the factional reserve system -- meaning that banks need keep only a small fraction of depositors' money as a reserve.

    So here's the deal. Joe thinks he has $20,000 down at the local bank. The local car dealer actually has Joe's money. Meanwhile you have a car for which you are diligently paying the bank. Money has been multiplied.

    Then you fall on hard times and are forced to declare bankruptcy. The bank might get some of its money back. They may even repossess your car and sell it. But you no longer have a liability, and the bank has lost an "asset" or a portion of it. Money has disappeared from the system, because all fiat money is debt-based and some debt has been "destroyed" by the bankruptcy. The bank still has to cover Joe's $20,000 deposit, so it has to rebuild its reserves somewhat and can make fewer loans (create less money) because it can no longer count on you giving them more of your money every month.

    This what should happen in all economic cycles. You have an inflationary bubble of economic activity and investment which then corrects itself with a deflationary cycle of debt-elimination as "assets" are charged off and losses taken by lenders.

  5. This is indeed complex.
    So applying that to the big scale (say bankrupting countries or states) when a large, huge bankruptcy happens, do you think we should keep the cash or try to buy metal?

  6. Bankrupting countries that can print their own money runs a little differently. As debt increases, the central banks will try to buy it up and devalue their way out.

    When the derivatives scheme came about in 2008 we would have headed into a deflationary collapse because several trillion evaporated. The purchase of bonds by the Fed injected some money into the system during QE1, and we would have had price stability for a while. Except QE2 started which has created some significant inflation.

    I think there is going to be inflation because heavily indebted countries which cannot pay their bills cannot afford deflation. They would have to drastically cut expenditures.

    Metals are not going to make you rich. They will generally retain some value, and it's good to have some. I keep thinking gold will correct somewhat to about $1200, but I may be very wrong about that. Silver seems fairly reasonable at the moment. Someone commented a while back about saving nickels, which are worth more as metal than their face value. That's something that's really easy to do.

    Buy food. Seriously, canned beans or ravioli or whatever it is you like to eat until the pantry is full. The worst case scenario is that you will end up eating it. So don't stockpile weird stuff that you don't really like. Canned goods will keep for 12 months or so -- if they are acidic. Low-acid foods like tuna, salmon, and Spam will be good much longer. I've seen things that say up to five years -- I don't know, but a couple of years shouldn't be a problem.

    The point is that you are not going to look foolish or waste your money if you invest in food. So you have an excessive amount of salt, sugar, and flour, you'll use it eventually, even if the economy rights itself.

    I am concentrating mainly on buying things I know I will use, or goods that I think might be of value in trade. Get stuff that would be hard to MacGyver like work boots and gloves, or stuff you can MacGyver with -- caulk, duct tape, adhesives, fasteners, #12 smooth wire, etc.

    You want to be able to pay your taxes and utilities and have some reserve, but other than that, it is probably better to have stuff that you would use gold to get than to have an excess amount of the gold itself. You know what I mean? Firearms, ammunition, generators, fuel, tools, productive land, domestic animals, warm clothing -- all that stuff is useful now and in the future regardless of the direction things take.