Issue 1122 November 2, 2011
FRENCH FRIED BANKS
Ben Bernanke is in panic mode. The November 30
coordinated announcements of six central banks regarding
their intervention into the currency markets was exactly
that -- coordinated. If you think it was coordinated by
anyone other than Bernanke, you are out of touch with
reality. (Test: name the heads of at least two of the other
five central banks.)
As I shall argue, this was an action preliminary to
(1) Angela Merkel's December 2 speech to the German
parliament, which is preliminary to (2) the next Eurozone
summit, scheduled for the weekend of December 9, which is
preliminary to (3) a coordinated violation of the two
treaties that created the European Union, which is hoped
will (4) pressure the European Central Bank to buy newly
created Eurobonds issued illegally by the EU, in order to
(5) raise enough euros fast enough to buy Italian
government bonds before (6) the Italian government misses
interest payments, which may (7) bankrupt the largest
French banks, which could (8) trigger a worldwide financial
panic.
In short, Bernanke and his peers are in a pre-panic
panic.
DECIPHERING THE ANNOUNCEMENT
This was an announcement of a very specific kind.
Ninety minutes before the American stock markets opened,
the six central banks said that they would increase the
availability of money.
The Bank of Canada, the Bank of England, the Bank
of Japan, the European Central Bank, the Federal
Reserve, and the Swiss National Bank are today
announcing coordinated actions to enhance their
capacity to provide liquidity support to the
global financial system. The purpose of these
actions is to ease strains in financial markets
and thereby mitigate the effects of such strains
on the supply of credit to households and
businesses and so help foster economic activity.
In short, The FED assured us, they were acting on
behalf of the best interests of common people around the
world. They were doing this in the name of the People.
"What's good for the People is good for central bankers."
The problem is, they were silent on why, exactly, the
strains of the supply of credit was threatening the People.
On November 29, the interest rate for 90-day U.S. Treasury
bills was 0.01%, or one one-hundredth of a percent, which
is the lowest it has been in history, basically. To be
honest, I do not regard this as evidence of a strain in the
financial markets.
This raises these questions: "Which financial markets?
Paying what rates? Why?"
In the good old days, meaning earlier than November
30, "strain in the credit markets" meant a frantic rush by
investors and speculators to purchase a financial asset.
The asset's price rises rapidly, which is what happens when
there is greater demand than supply for any asset.
The U.S. dollar has been bumping around in relation to
the euro all year. There has been no indication of a
frantic rush to sell euros. On January 1, 2011, a euro
bought $1.34. On November 29, a euro had fallen in price to
$1.33. (http://bit.ly/DollarEuroRates) That was not what I
would call a strain on the euro market. We are not talking
even nickels and dimes here. We are talking pennies . . .
in single digits.
So, the question arises: Why was it necessary for a
coordinated intervention? The FED explained:
These central banks have agreed to lower the
pricing on the existing temporary U.S. dollar
liquidity swap arrangements by 50 basis points so
that the new rate will be the U.S. dollar
overnight index swap (OIS) rate plus 50 basis
points. This pricing will be applied to all
operations conducted from December 5, 2011. The
authorization of these swap arrangements has been
extended to February 1, 2013. In addition, the
Bank of England, the Bank of Japan, the European
Central Bank, and the Swiss National Bank will
continue to offer three-month tenders until
further notice.
This is central bank gibberish. It refers to the
practice of lending U.S. dollars for a period of time.
These are central bank loans to other central banks. They
are called central bank liquidity swaps. For a description,
see Wikipedia: http://bit.ly/CBls. Say that one central
bank needs dollars. It can swap its assets for dollar-
denominated assets for a fixed period of time. In this
case, the deadline is February 1, 2013.
The five other central banks promised to supply
liquidity, meaning their own currencies.
As a contingency measure, these central banks
have also agreed to establish temporary bilateral
liquidity swap arrangements so that liquidity can
be provided in each jurisdiction in any of their
currencies should market conditions so warrant.
At present, there is no need to offer liquidity
in non-domestic currencies other than the U.S.
dollar, but the central banks judge it prudent to
make the necessary arrangements so that liquidity
support operations could be put into place
quickly should the need arise. These swap lines
are authorized through February 1, 2013. It can
therefore supply dollars to those who demand
them.
So, the problem is the dollar. Better put, it may soon
be the dollar. But, just in case, the central banks are
willing to inflate.
At this point, I can imagine an exchange between a
confused caller and some call-in satellite radio investment
show.
But won't the free market do this? "Yes, but
at a higher price."
So, the coordinated action was a move to
keep down the price of the dollar. "You've got
it, Sherlock."
So, the other five banks are working with
the Federal Reserve to keep the dollar low, which
will reduce their nations' exports to America."
"That's one effect."
But that means the central banks are acting
to hurt their own export markets. "That is one
effect."
But central bankers never do this. "This
time, they are."
Why? "Because they are scared out of their
wits."
To get some indication of what the coordinated action
is intended to accomplish, pay attention to this.
In addition, as a contingency measure, the
Federal Open Market Committee has agreed to
establish similar temporary swap arrangements
with these five central banks to provide
liquidity in any of their currencies if
necessary. Further details on the revised
arrangements will be available shortly.
So, the FED thinks there is a chance that there will
be an increase in demand for dollars in other currencies:
"to provide liquidity in any of their currencies if
necessary." So, more than one of them are afraid of a
panic-driven sell-off of their currencies.
Are they all equally at risk? No. There has to be one
targeted bank: the central bank of the currency that is
being dumped by investors in order to buy any of the
others. Which might that be?
It is obvious: the European Central Bank.
But the euro has been stable in relation to the dollar
all year. It is obvious that Bernanke and five other
central bankers think that this rosy scenario is about to
end.
U.S. financial institutions currently do not face
difficulty obtaining liquidity in short-term
funding markets. However, were conditions to
deteriorate, the Federal Reserve has a range of
tools available to provide an effective liquidity
backstop for such institutions and is prepared to
use these tools as needed to support financial
stability and to promote the extension of credit
to U.S. households and businesses.
http://bit.ly/FEDswapdeal
The FED said that U.S. financial institutions are not
having problems getting access to dollars. Furthermore, the
FED "has a range of tools available to provide an effective
liquidity backstop for such institutions." Then why the
swaps? Why would five other central banks join in? Why
should they need to worry about "such institutions"?
Simple: the central bankers are not worried about U.S.
financial institutions. They are worried about their own
financial institutions. They have good cause to be worried.
FRANCE'S BIG BANKS
With a useful interactive graph in the "New York
Times," we can see which nations owe how much money to
which other nations' commercial banks.
http://bit.ly/NYTdebtgraph
The chart reveals something ominous. French banks are
sitting on top of a mountain of Italian bonds. What if
Italy decides to create what I have elsewhere called an
"Iceland event"? It could be a disaster!
http://bit.ly/IcelandEvent
Europe will then have French fried banks. Then the
question arises: What will Sarkozy do? How will the French
government get the money it needs to bail out its now-
insolvent big banks? Who will lend it this money?
The money needed will be euros. But, under the present
laws governing the European Union, the ECB is not allowed
to buy bonds of nations that are considered poor credit
risks. France will be a bad credit risk if Italy skips
interest payments, let alone defaults.
Then what is the FED's problem? This: if Merkel does
not get her government to accept instant inflation by the
ECB, but without a revision of the Maastricht and Lisbon
treaties, then she will go into the December 9 summit as a
barrier to a quick decision by the ECB. The summit will be
stuck.
The threat of Italy's default is imminent. If the ECB
does not act, and act fast, then the Eurozone will be seen
as approaching a break-up. This means the euro may not
survive. That fear may trigger a run on the euro: a mad
dash to sell it and buy U.S. dollars. If dollars are not
available at a price people are willing to pay, then there
will be a rush to buy other currencies.
This is the much-feared, long-denied domino effect.
The orders to sell euros are placed by people with big
money: hedge funds. They want instant conversion. They will
also start looking for safe-haven banks located outside the
Eurozone. They will fear a Lehman event. This is what an
Iceland event can become if Italy defaults. It owes too
much money.
At that point, the ECB will be pressured to intervene
to prop up the euro. Question: Intervene with what? With
U.S. dollars. Where will it get these dollars? From the
FED.
This is what the coordinated announcement was designed
to forestall. This is the "bazooka."
TWO BAZOOKAS
What is the bazooka? It was the word used by then-
Secretary of the Treasury Hank Paulson to describe his
promise that the Treasury would provide funding for the two
visibly tottering, over-leveraged mortgage companies,
Fannie Mae and Freddy Mac. He told Congress: "If you've
got a squirt gun in your pocket, you may have to take it
out. If you've got a bazooka and people know you've got it,
you may not have to take it out." This has been identified
as one of the 21 dumbest business moments in 2008.
(http://bit.ly/BazookaWarning) Two months later, both
outfits went bust, and Paulson, on his own authority,
nationalized them. The taxpayers picked up the tab. Michael
Pento commented on this on November 14.
But years after Secretary Paulson fired his
bazooka, those formerly thought of as "safe"
investments are now trading at just pennies a
share. And just last week the government or more
appropriately the taxpayer was forced to throw an
additional $7.8 billion at the GSEs for the last
quarter's losses. That was on top of the $169
billion they have already spent to rescue the
black holes known as Fannie and Freddie since
2008.
Pento then commented on the newly installed head of the
ECB: "Similarly, Draghi now believes that the problem with
European debt is fear, not one of insolvency."
And just like Hank, Mario will soon learn that
offering to purchase an unlimited amount of
Italian debt does nothing in the way of bringing
down the debt to GDP ratio. In fact, it has the
exact opposite effect. It encourages more
profligate spending, just as it also lowers the
growth of the economy by creating inflation.
What's even worse is that yields on Italian debt
will reach much higher levels in the longer term.
That's because the purchasers of sovereign debt
have now become aware that their principal will
be repaid with a rapidly depreciating currency.
Therefore, the yield they will require in the
future must reflect the decision to use inflation
as a means of paying off debt.
http://bit.ly/ECBbazooka
This is the first bazooka. The joint announcement of
the six central banks is the second. This one tells the
world that any rush out of euros into dollars will take
place in an orderly way.
A PANIC-DRIVEN SELL-OFF
I assume that Prof. Bernanke understands the #1
principle of chapter 1 of any college-level economics 1
textbook: "When the price of any scarce resource falls,
more is demanded (other things remaining equal)." This is
described graphically in the famous intersecting S/Q supply
and demand curves.
The economist assumes that the reason why demand
increases faster than supply does is because speculators
believe that the price of an asset will rise. So, they buy
it now. In the case of currencies, they sell one and buy
the other.
Why would speculators buy dollars and sell euros?
Because they fear a major event that will threaten the euro
as a currency. So far, the price of dollars in euros has
not revealed any such imminent fear.
It is clear that the central bankers think this lull
in the storm is unlikely to last much longer. So, they
hauled out the bazooka.
What are they aiming at? They did not say. We can
figure it out.
TIMING IS EVERYTHING
If French banks lose the value of Italy's bonds on
their balance sheets, some of them will face bank runs.
This could easily cause a system-wide banking panic in
France. That panic could spread to other nations'
commercial banks.
This will not be allowed by the Powers That Be. They
will find some loophole to bail out the banks. But they
would prefer to implement it soon, before the dominoes
start falling.
Strategically, the public support of Italy is wiser.
The Powers That Be don't want to face an Iceland event. At
that point, they would have to save France's big banks. But
the Powers That Be are the big banks. There will be panic,
bank to bank, national banking system to national banking
system. They want to forestall this.
The first bazooka -- the ECB saving Italy -- needs a
legal cover. There has to be an annulment of the treaties.
The ECB will be hesitant to fire the bazooka if it is not
given authorization.
What if it isn't? What if the crisis hits Italy before
the annulment can be codified by some cooperative
announcement by the summit -- an announcement that the
members can get their governments back home to agree on?
That's where the second bazooka comes in. The FED will
supply dollars to the ECB, which can then sell them to
investors fleeing the euro.
Back to economics 1. If you can see that the supply of
any asset will run out, and there is a rush to buy, it will
do no good for the sellers to promise more of the sought-
after asset. They will not be believed. The low price
subsidizes skeptics to buy even more. At a lower price,
more is demanded.
So, the central bankers have to hope that there will
not be a panic run out of the euro into the dollar. They
are buying time. They have a deadline: February, 2013. So,
they think that the panic will be short-lived. A show of
force -- a bazooka -- may cut it off before it begins.
Note: it didn't work for Paulson.
They must assume that a panic will force the hand of
the ECB to inflate and buy either Italian bonds (early) or
the debt of the French government (late), which will lend
money to the largest French banks. The second bazooka is
supposed to lend credibility to the first one: the one the
ECB could use to save Italy from default. The ECB's
managers at present are afraid to invoke it. "We are not
going to use it."
If the ECB fails to act fast enough, Italy could cease
making payments. A run on large French banks could begin.
That will force the hand of the ECB. The central banks have
handed the ECB lots of bazooka ammunition.
CONCLUSION
Bernanke and his peers are in panic mode. They are
taking steps to deal with a run out of French banks and
maybe out of the euro. They are in effect subsidizing this
run, assuming that the ECB sells dollars to all buyers who
bid. I think the goal is to sell to big banks only -- those
being hit by runs. They will do this because they don't
think the panic will last beyond January 2013.
We shall see how much longer Italy continues to make
its interest payments. Long-term, Italy will default. There
will be an Iceland event. I think there will be more than
one.
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