"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Friday, November 26, 2010

Part II: The EU Emerging Fiat Model

In Part I, I addressed what this series of posts will focus on, and how the US Fiat model is currently evolving.  It has completely diverged from the private sector debt growth model that was created after the end of Bretton Woods in 1971.  I think it's important to keep in mind the economic ramifications of such a debt based model.  It fundamentally changes the banking system as laws are re-oriented (financial de-regulation, to be exact) to strengthen the financial sector.  The economy too, is thus fundamentally changed.  It migrates from a production based to a debt based consumption and speculative (ponzi model) economy.  This also affects the power structure of a nation - financial interests assume a greater role in government policy.

Some EU history

After Bretton Woods, Europe too fundamentally changed.  No longer would their dollar surpluses be exchanged for dollars, but Treasury debt.  The cold war was still raging and there was an implicit agreement amongst the Western nations.  The USSR was a threat, and Europe and other nations would buy US debt instead of exchanging their dollars for gold, in return for US "protection."  That would be NATO and the US military in general, of course.  The rest of the industrial world, as well as the Middle East, would be basically financing America's Military.

This arrangement also had the effect of allowing Europe to increase its social safety net - its expansive government benefits.  Europe didn't need to spend as much on military matters, as the US, in that bipolar  USA/USSR world, was their protector against the USSR and the Iron Curtain.  Western Europe didn't exactly get a free ride, don't forget, their accumulated surpluses were exchanged for US government debt.  Foreign Reserves/Balance sheets no longer focused on the accumulation of gold or gold backed money - which is an asset with no counterparty reliance, but now surplus gained thru trade was exchanged for US (and other countries') debts - someone else's liability.

And thus, as surpluses grew through global trade amongst the Western Industrialized world, so too did the other side of the balance sheet - liabilities.  Or as non-economist types would call them: debts.  The game became debt based.  Debt equaled consumption and wealth.  Don't get me wrong, it always had to a degree, but what changed was how nations keep "score" in global markets.  Debt was good and sought after.  Global wage arbitrage and central bank manipulation also kept debt cheap as inflation was kept in check by increased trade with what we used to call the "third world," and interest rate manipulation by central banks.

The EU, after decades of limited political integration successes, decided on a grand experiment: monetary integration, the European Monetary Union (EMU) thru the Treaty of Maastricht.  And thus, in the 1990s, the exchange rate mechanism (ERM) was born.  Before the creation of the Euro, EU member currencies would have to trade within a narrow band.  Or as someone described the process: the various EU currencies would be dancing to the drum of the Deutsche Mark, the strongest currency in the group.  Speculators did their best to knock off these currencies from their narrow preset price ceilings/floors.  George Soros' war on the British Pound was one famous example.  He successfully knocked the pound out of the ERM.

Some have even speculated that Soros was doing the bidding of others - others more powerful than him that did not want English EMU with the continent.  but I digress...

The EU Grand Experiment

But enough of the history, the best way I can describe EMU is that it requires the Euro to act as a gold standard of sorts.  It's not officially backed by gold, but gold reserves are marked to market, and stringent guidelines are set that dictate allowable member states' debt levels.  It was not enough that the member states' currencies had to maintain price stability before EMU integration, but that their respective governments needed to have manageable debt levels as well.  And so, paper money was to be as scarce yet as valued, as gold.  From Wiki:
Annual government deficit:
The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.
Government debt 
The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
But there was a problem:

Quite a few member states, in order to enter EMU and adopt the Euro, lied about their debts. Yes, some lied more than others, but the fact is, the foundation of EMU, from the get-go, was a farce.  But what's even more important now is that they are just about all in violation of Maastricht.  Remember the 60% government debt to gdp, and 3% of gdp budget deficits?  Here are statistics for last year:

The top right hand box is where a nation does not want to be - these are the countries that are in violation of Maastricht.  Quite a large club, no?

And so the EU faces a crisis.  But it is not just a crisis of complying with a Treaty from 1991, it is an actual solvency crisis.  The bond vigilantes are out in full force.  And yes, at times, it seems like they go away, but overall, they are acting the way markets should act.  That is, when economic policymakers can not succeed in keeping their countries solvent and economically viable, the market will punish them with high interest rates.  The party is over.

Making Paper Act Like Gold

So how is fiat money evolving in Europe?  Well, as I explained in Part I, the US is saying to hell with deficits, and to hell with debt monetization - if fiat money is a fiction  that can be created with a keyboard stroke, we'll just keep creating more and more of it.

Europe, on the other hand, is trying to recreate and maintain the initial goals of EMU and the Euro. They want it to act like gold.  They want their currency to be strong as opposed to the US Dollar.  But you know what?  Ironically, that policy will just ensure that the fiat Euro dies before the fiat US Dollar dies.

You know why?  Because austerity is worse than the gold standard.  It's a question of timing.  Think of it as overeating for years.  Not only do you gain weight, but your stomach expands, requiring more food to fill it.  You get hungrier more often.  Europe has been accustomed to a certain level of debt and a certain level of debt growth.  To throw Europe on a starvation diet not only accomplishes the intended goal of losing weight, but it also has unintended consequences.  You will have one pissed off and at times, weak patient.

Austerity has real consequences.  It has societal, political, and economic consequences - all destabilizing.  One only needs to read the paper to see that Europe has become a continent of weak governments, enraged citizens, and economies suffering debt destruction/depression.

And so Europe's Fiat Model is taking the gold path without a gold revaluation - which in my opinion is extremely deflationary.  That's why the US Dollar isn't tanking against the Euro post QE2.  Either you have a gold backed currency or you don't.  Period.  You can't make paper act like gold after the fact - that is, after a decade of extreme fiscal irresponsibility!  If you want gold, then revalue your currency - accordingly.  Otherwise this is what you will accomplish:

But before I say that Europe will definitely commit the suicide of its currency, I want to mention a recent development.  I always keep an open mind, because facts are always changing.  My overall opinion is that fiat will end and gold will resurface as official money in some way - by default, not by plan.  But it's the path(s) taken that may change.

It is becoming increasingly obvious that the fund the EU set up for addressing potential sovereign defaults, the EFSF rescue facility, is inadequate.  Spain is the "elephant in the room" as Nouriel Roubini recently put it.  And so, from The Irish Times:

ECB shift from lender of last resort casts doubt on independence

"THERE HAS been a most profound change in the European Central Bank’s (ECB) approach to monetary policy over the last two weeks, produced in great part by the financial crisis in Ireland.

This change has involved the ECB running for cover from its role of lender of last resort to the euro zone banking system, and in turn seeking some assistance from the European Commission with respect to co-insuring its lending to the banking system."

Full Article HERE.

And also from ZeroHedge:

Die Welt: EU Commission Is Considering Doubling Size Of European Financial Stab [sic] Fund

And so, even though this series of posts is about the two paths of Fiat Evolution, the EU may soon find itself so overwhelmed, that it may take on the US path.  I'm not saying it is a certainty, but it is possible.  As I said earlier in this article, the current EU path of handling fiat money is destined to fail before the US path does.

In the final part, which I hope to post next week, I will compare the two systems in greater detail and make some forecasts.

Happy Weekend.


Anonymous said...

Great series man.

I would just like to add 'rioting' if you will is not that uncommon troughout recent european history.

You don't have to go far back in history to witness civilian upheaval over policies that often led to people actually dying even.

I would even dare to state a public not afraid to air it's discontent is actually beneficial to the longer term prospects of a country in the long run.

Not saying dislocation is not happening and that it couldnt get any worse but I am saying historically things aren't that bad yet and not to much connotation between civilian uprising and the economy should be read.

Remember the LA riots in the 90's? And yet as turned out those were the good times. :-D

Part of it obviously also has to do with the standoff between the Anglosaxen (press) and the German French block who both have an interest in portraying the others economic and social fabric as weak and unsustainable.

Misthos said...

You are absolutely right. Unfortunately economists and politicians can not measure the variable of popular revolt - whichever form it takes.

Protests, revolts, etc... are natural brakes in the system. Once they get out of hand, economic policy shifts accordingly. And all the best laid plans, however well intentioned by elites, are finished or at best compromised.

Many initially characterized the Greek protests as indicative of a southern country that protests as a pastime. But we have seen the same recently in Germany, France, the UK, and now Ireland. It's not a Greek thing anymore. It's a socioeconomic phenomenon rising out of the unfair socialization of bank losses and mismanaged governments. It's also political - arising from the increasing realization that individual sovereignty is eroding.

What can we expect from the masses as more people feel economic pain, and as Brussels and Frankfurt assume a greater role in their countries' management? Even the most brain-dead peasant will eventually conclude that Brussels (the EU) and Frankfurt (the ECB) are running things in his country now, and he will attribute his economic suffering to this loss of sovereignty. I'm afraid that policymakers are underestimating this variable.

As for the Anglo-Saxon vs. Franco-German debate. I agree, it exists and I wrote about some developments that involved France, Germany, and Russia meeting in Deauville a while back. These are all tied together.

I find it hard to believe that behind closed doors, elites are not scared to death of our changing world. They have to deal with their restless populations and a growing re-alignment of alliances - economic and political.

There is no global cooperation. The world is fracturing. Hence, my view, gold by default.

Dave Narby said...

Very much appreciating your writing Misthos.

It's true that the USA doesn't have a history of national rioting, we seem to have our fair share, and they seem to cluster around periods of financial or civil strife (depressions, recessions, and the civil rights era stand out).


Another reason we tend not to riot in the USA is we have a lot of guns. Personally, I really, really hope we manage to keep the riots to a minimum.

One thing really stood out about the Maastricht treaty: Where's the "or else"?

It seems to me the "or else" is that you would be removed from the EMU. But given that the debt is so interconnected, the "or else" seems to have turned into the old saying "If you owe your local bank $100k, you have a problem. If you owe your local bank $10M, they have a problem.".

Dave Narby said...

Forgot to add this: This fellow has been following up on the work of The Fourth Turning authors, I think you might find his analysis of history useful http://www.generationaldynamics.com/ww2010.htm


Misthos said...


Other factors I attribute to US complacency:

The US has had the "exorbitant privilege" of hosting the world's reserve currency, and thus has historically been the world's #1 consumer. The US also has a rather stable domestic history. I think these factors also have contributed to US complacency compared to Europeans.

Europeans also live amidst history. There are castles, memorials, battlefields, etc.. everywhere. Here in Greece, many remember the military dictatorship of the late 1960s and early 1970s, as well as the German occupation.

As for Maastricht, you bring up a good point. There are no teeth in that treaty that have been used. Germany has become the de facto leader as they are bearing the brunt of the costs. But they are trapped too - their banks are highly leveraged. Their banks, too have acted irresponsibly, yet are they being punished? It's a mess - the "interconnectedness" of markets has created wealth on the way up the debt pyramid, but on the way down, that same interconnectedness is showing us a rather troublesome picture.

Thanks for the link on the 4th turning, I'll check it out.