Gold News

Beware the Euro Cake

Plans to solve the Eurozone crisis won't work if they're too tightly focused...

HERE'S A QUESTION. If investors in Greek government bonds face a 60% loss on their bonds instead of a 20% loss, what will that do to them? asks Dan Denning, editor of the Daily Reckoning Australia.

Those investors are European banks. And those banks are the banks that already need some €108 billion in new capital by the end of next year. Won't they need more if their Greek losses are larger?

Stop!

Before we go any further into the details we should highlight the big problem: everything affects everything. If you make a "grand plan" to recapitalize the banks and prepare for the next crisis, but your plan depends on Greek bond losses being fixed...well, your plan is screwed.

This is why the Europeans are doing a lot of talking but not much else. The latest news is that everything will be revealed on Wednesday. The Greek write offs, the bank recapitalization plan, the funding of the bailout mechanism, which is meant to restore confidence in Italy and Spain and prevent borrowing costs from rising there...all of that should be ready by, let's say, Wednesday.

There is a problem in all this that we are trying to get at. We spent most of the weekend thinking it over. The problem is not economic or financial. It is philosophical.

At one level the problem is easy to understand: too much financial complexity. We'd argue this is a result of a monetary system in which money is not a real thing (a commodity) but an idea. When money isn't a real, tangible thing, it makes the creation of complex, fantastical financial models possible.

For example, the Europeans are looking for ways to "leverage" the size of $529 billion European Financial Stability Facility (EFSF). By "leveraging" it they can make it larger than it appears, which gives the illusion that the fund can do more work. One example is to use the fund to insure holders of Italian and Spanish bonds against losses.

But you can see the problem here. Using the fund to insure bondholders against losses is designed to restore confidence in Italian and Spanish debt. Assuming the Italians and the Spaniards can get their government deficits under control...well then everything will be fine, won't it? The crisis will pass. Growth will resume. Nothing bad has to happen.

Mind you, Italy has $2.57 trillion in government debt. That's 120% of Italian GDP. It's the third-largest economy in Europe. If tiny little Greece can nearly bring Europe undone, what about big bad Italy? This is what the 27 members of the European Union fear, and the 17 users of the common currency...a complete breakdown of their artificial monetary union.

"Leveraging up" the EFSF amounts to making it look bigger than it actually is. A simpler way of saying this is that the Europeans don't have enough money to pay off their collective debts. Their solution is to make a small amount of money punch above its weight. This isn't going to work.

These complex financial schemes are the Crystal Palaces of the Financial Age. But of course, they are pure accounting fictions. Not real things.

The Crystal Palace was a steel and glass monument to the Industrial Revolution. It was the physical embodiment of an idea. The EFSF, by comparison, is a disembodied idea. It is an abstraction. It is the idea that increased leverage can disguise real insolvency.

But if we were to describe it as a real thing – in fact if we were to describe Europe's predicament as a real thing – we would describe it as a magnificent 17-storey wedding cake that's been dropped from a very tall building.

A camera zooming in on the details of the cake would show you layer after layer of solid, delicious-looking cake. You'd see the delicate icing, the 17 happy brides and grooms on top, saying their vows at the altar of centralization. You'd see little roses and fleurs de lis and beautiful embellishments of incredible complexity and finery.

But all the while, the cake would be falling toward the ground, accelerating at 9.7536 meters per second per second. No amount of refinement would delay the inevitable work of gravity. Yet if your vision were focused too narrowly on the cake itself, you would not notice the arc of its flight. Or that its flight was really a plunge.

The cake is falling. We may be ignorant of what happens when it lands. But for goodness sake, don't stand under it!

And you may want to be clear of the splat zone altogether, although here the metaphor breaks down. To be splattered with cake doesn't seem that bad compared to owning a portfolio of crashing financial stocks. Still, beware the cake shrapnel and possible collateral frosting.

Buying Gold?...

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles
 

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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