The Financial Multipliers of Globalism and Ross Perot’s Giant Sucking Sound

Fed Chairman Bernanke testified last week that “the situation in Europe poses significant risks to the U.S. financial system and economy”. This indicates the extent to which financial globalism has become a controlling factor in U.S. economic and financial prospects and policy.

While globalism wasn’t supposed to have that level of influence, there was a memorable warning in the great North Atlantic Free Trade Agreement (NAFTA) debate of 1992. As it was conceived of at the time, globalism meant trade rather than finance, and became a presidential campaign issue. It was at that time that Ross Perot famously associated globalism with a “giant sucking sound” of jobs being lost to low-wage countries.

Today, the issue is financial globalism, not trade,  and per Bernanke’s above statement, all efforts are being made to contain or “ring-fence” Euro sovereign and bank meltdown from also taking down the rest of the world’s financial asset valuations and the solvency of the institutions holding those assets.

This is not easy when Euro banks are highly leveraged, perhaps 30 times and funded by short-term financial claims such as deposits or Repo loans that can and do run without notice. This forces the sale of the banks’ troublesome assets, not just for liquidity to retire deposit but also to downsize the book of assets by the above leverage multiple for each dollar of declining net worth.

That all fits the description of a financial crisis (as previously explained in Dominos) but what makes it even more of a government crisis is when the bank’s questionable assets are government debt. The forced selling with few buyers and declining prices only makes it more transparent that the government is near insolvent and can’t backstop the bank’s insolvency as well.

This unstable equilibrium is destabilized one step further when other arm-twisted governments are coerced into providing bailout aid, because the costs of the spreading financial meltdown to them exceed their bailout costs. So the implication of financial globalism is indeed the giant sucking sound of sapping resources across the globe into a financial black hole which used to be called Greece, Ireland and Portugal but is now also called Spain.

This is done with a large multiple of the original bank asset write-downs as all banks are run, and in turn forces business firms to be cash-hoarding machines instead of expanding producers. The combined corporate stock market meltdown and bank asset sale meltdowns create financial multipliers of lost market value perhaps 10 to 20 times the bank’s actual defaulting assets. Such was the experience of 2008.

If the central banks are called in and they are indeed poised to spring into action, it would require a substantially larger asset purchasing infusion than the insolvency losses in the first place. This is because the multiplier of financial shrinkage due to a dollar loss of bank capital is far greater than the melt-up multiplier of a dollar of central bank liquidity. Banks are short of capital and don’t in turn expand with a money supply multiplier of textbook lore when central banks expand, which explains why central bank QEs are in the trillions when the bank losses causing the interventions are in the billions.

So here we are with governments and central banks poised to react with the old game plan of QEs to inject purchasing power into asset markets, but what we need is a new game plan with a reduced vulnerability to global financial interconnections unless fiscal sanity re-emerges. Hence, ring fencing or financial containment means the end of financial globalism as was developed over the last decade.

As the world moves away from financial globalism, expect one of the first and obvious disconnects to be Greece divorcing itself from the Euro currency — or, more rationally, for Germany to come to grips with the idea that they set themselves up to be the easy mark in the Euro game of wealth redistribution.

In response to prospective Euro breakup, both borrowers and lenders are re-aligning themselves to be borrowing and lending in the same country as cross border finance means one might end up holding assets in a declining country currency and owing in an appreciating currency. So private parties are de facto withdrawing from financial globalism even before governments constraints set in.

If and when Greece exits the Euro, financial markets will likely fade for a few hours until it collectively realizes it is better for Greece, Europe and global financial markets, and the flight to the U.S. Treasury and German Bund will recede.

Financial globalism has become a transmission mechanism to spread financial losses across the globe.  Hence, the pendulum of financial globalism is now swinging the other direction. Ironically, it will reinforce the reserve currency status of the U. S. dollar despite the U.S. fiscal problems.

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The Anatomy of a Financial Meltdown

The Euro debt situation continues to deteriorate and the U.S. is not far behind. All the distress that is now focused on government debt comes from excessive private indebtedness as developed world countries seek to support the private sector. This has shifted the debt burden to the government sector, and now the government is the problem, not the solution. This is the outcome of a debt-bloated economy. For more background on this topic, I recommend that you watch the splendid discussion I had with Dr. Lacy Hunt a week ago — the video, “The Morass of Debt,” is linked and posted below. It covers the extreme difficulty of resurrecting an economy that has a debt overload. Regarding the Greek debt containment status, consider the following;

The grand containment scheme — as noted in the previous two posts, “Why These People Are Smiling” and “As Greece Goes So Goes Europe: How the Unthinkable Happens” — continues to deteriorate. Cover-ups tend to unravel when there is a hole so large and getting larger relative to the resources available to fill it; this happens even faster when the cover-up involves so many moving parts and requires so many volunteers to take the hit, particularly when there are strong private incentives not to volunteer. A partial list of the unraveling of the past week is as follows:

The banks that were to rollover Greek debt at ridiculously low yields, considering their risks, have largely already dumped their bonds to get out of the charity business.

The rating agencies have shown some backbone (or creditability survival instincts) by downgrading Portugal and Ireland to junk, expanding the necessary cover-up.

Depositors are fleeing Greek banks (and probably others, as short-term funding rates in Europe rise), creating a liquidity crisis in which banks are loath to lend to other banks for fear of a default. A liquidity crisis morphs into a solvency crisis if banks are forced to dump bad assets at the already depreciated market terms and dump otherwise good assets at deep discounts to fund the deposit withdraw. Each asset sale is noted by the bank accountants as a reduction of income and capital.

Greece and other Euro banks are under a depositor flight that used to be called a bank run. The ECB is called in to lend to these banks, but the rules require investment-grade collateral for these loans. Since the banks do not have unpledged investment-grade collateral available, the ECB has indicated that it would accept virtually any opinion of quality (besides those of the three major rating agencies, which are now being realistic) to qualify as lawful collateral. The standards are depreciating, and the ECB will be left holding the bag of bad assets, adding to the loss of confidence in holding wealth denominated in the Euro.

To make matters even worse, a new bank stress test is supposedly being released that will make some ludicrous assumption of the value of government bonds. It is an intended cover-up of the situation and will add to Knightian Uncertainty —increased uncertainty from not having the facts to evaluate the risk causes depositors to flee and markets to sell off banks’ stock, making it impossible for banks to raise replacement capital of any form, except for the charity of the central bank.

In order to prevent financial insurance claims, the rules of the game are being altered. A “limited” Greek debt default is being created for the “volunteer” banks that are being forced to roll over Greece’s debt at below-market yields. The” limited” designation is to provide the basis for the argument that all other Greek debt outstanding is good, hence protecting against a financial insurance payout. We’ll see if that holds up in court as those who took out insurance want it to be paid — but that will be much later.

And now, Italy has come into focus as the second “I” in “PIIGS.” The market is turning against their bonds.Lastly the IMF, now under the former French finance minister (as of a week ago), is hardening its terms to provide budgetary help to Greece. It sea former classmate of mine, as the outgoing IMF acting managing director, pushed through a higher hurdle for Greece’s lending before the arrival of the Madame from France. Furthermore, the IMF is sticking to it as the developing countries are in the process of reining it in to prevent it from being an exclusive developed world slush fund.

There is more trouble for Greece and the PIIGS: Not only do they have debt that can’t be sold in the market and political inability to contain deficits, but the veterans of sovereign defaults from Argentina looked at the situation and claim the Greek situation is DOA (my interpretation). They point out that even if all Greek debt were somehow to disappear via default without any compensation to the debt holders whatsoever, Greece still runs a fiscal deficit.

Furthermore, in a very insightful piece, John Gilbert of GR-NEAM questions the sustainability of Greece and Portugal’s economies apart from the burden of past, present and future debt. It seems these countries have an extreme dependence on foreign energy that causes their trade deficit to balloon when oil approaches its current $100-a-barrel price tag. That is, apart from debt, these economies are toast because they can’t export enough to pay for imported energy.

Lastly, the distressed Greek assets are not finding eager buyers who are ready, willing and able to pay what Greece had hoped for.

All of the above components are the makings of a financial crisis on par with the Lehman weekend. The banks’ condition no doubt will be favorably spun with the new stress test, and the market will still run the banks. Even the Federal Reserve is making noises about the possible need for a new QE this week (what a retreat from last week), pinning the problem on slow U.S. economic growth. But the Fed’s real intention, it seems to me, is to be poised to be lender of last resort to back up the ECB as depositors flee banks here and abroad, as they did in 2008 in amounts greater than $1 trillion.

This is the outcome of a leveraged financial system that has taken a large position in an asset category (government bonds) that has subsequently been deemed to be risky: It all cascades down. The financial institution assets depreciate, and the liability side of bank balance sheets is compressed when depositors run and the banks’ capital account is written down.  The market forces them to face the reality that neither the banks nor their governments wanted to face. Financial gravity ultimately wins despite the best and deceitful government efforts.

One aside: When Mexico was faced with a similar situation in 1982, banks were failing and depositors were fleeing. The response was to beef up the containment package by requiring government permission to exchange local currency for foreign currency, and on top of that, all banks were nationalized so the government could determine who was withdrawing pesos in a capital flight. Unless you stay one step ahead of regulation, you risk becoming a “volunteer” to help out the banks. I think most have had enough of that.

Now the important and relevant question is where the private wealth will flee. It is the question of the systemic flight to quality asset. The usual response, as it overwhelmingly was in 2008, was the U.S. dollar and the U. S. Treasury — but that depends on the perceived riskiness of the U. S. situation, which is not likely to be resolved before the Euro situation comes to a head. So it appears the answer will be that wealth will not flee to the usual places even if a U.S. debt ceiling deal is done on time.

This is a vital issue and I am working on an analysis of it, as all investors need a safe haven asset if they wish to preserve their wealth. Euro bank deposits are obviously not it, and U.S. investors might be shocked to understand that the usual “risk off” asset of money market funds is also not the safe haven it once was.