The Fed and ECB Are Strange Bedfellows

09/20/2011 8:30 am EST


John Mauldin

Chairman, Mauldin Economics

The Federal Reserve seems hell-bent on continuing to move into uncharted monetary territory along with the European Central Bank, but there’s a method to the madness, writes John Mauldin of Thoughts from the Frontline.

Yesterday, the Fed announced that along with the central banks of Great Britain, Japan, and Switzerland, it would provide dollars to European banks that have lost their ability to access dollar capital markets (basically each other and US-based money market funds that are slowly letting their holdings of European bank commercial paper decrease as it comes due).

And if they are “rolling it over,” they are buying very short-term paper, according to officials at the major French bank BNP Paribas.

Are US taxpayers on the hook? We will deal with that in a minute. The more interesting question is, why do it at all, and why now? Was there a crisis that we missed? Why the sudden urgency?

One of the little ironies of this whole Great Recession is that the central banks of the world rolled out this policy on the third anniversary of the Lehman collapse. The Fed acted after that crisis to provide liquidity. And we know the recession and bear market that followed.

The only reason for this move must certainly be that they are acting to prevent what they fear will be another Lehman-type crisis. Otherwise it makes no sense.

They can give us any pretty words they want, but this was not something calculated to make the US voter happy. To do this, you have to be convinced that “something evil this way comes.” And to recognize the costs of not doing anything, and try to head them off.

My guess is that the European Central Bank made a presentation to the other central bankers of the realities on the ground in Europe, and the picture was plug ugly. It should be no surprise to readers of this letter that European banks have bought many times their capital base in sovereign debt. The Endgame is getting closer (more on that in a minute).

Let’s look at just one country. French banks are leveraged four times total French GDP. Not their private capital, mind you, but the entire county’s economic output!

French banks have a total of almost $70 billion in exposure to Greek public and private debt, on which they will have to take at least a 50% haircut, and bond rater Sean Egan thinks it will ultimately be closer to 90%. That is just Greek debt, mind you.

Essentially, French banks are perilously close to being too big for France to save with only modest haircuts on their sovereign debt. If they were forced to take what will soon be mark-to-market numbers, they would be insolvent.

Forget it being simply French or Greek or Spanish banks. Think German banks are much different? Pick a country in continental Europe. They (almost) all drank the Kool-Aid of Basel III, which said there was no risk to sovereign debt, so you could lever up to increase profits. And they did, up to 30 to 40 times. (Greedy bankers know no borders—it comes with the breed.)

For all our bank regulatory problems in the US (and they are legion), I smile when I hear European calls for US banks to submit to Basel III. Bring that up again in about two years, when many of your European banks have been nationalized under Basel III, at huge cost to the local taxpayers.

Next, let’s look at the position of the ECB. They are clearly seeing a credit disaster at nearly every major European bank. As I keep writing, this could and probably will be much worse for Europe than 2008. So you stem the tide now.

But for how long and how much does it cost? A few hundred billion for Greek debt? Then Portugal and Ireland come to mind. If bond markets are free, Italy and Spain are clearly next, given the recent action in Italian and Spanish bonds before the ECB stepped in.

Could it cost a half a trillion euros? Probably, if they have to go “all in.” And that is before the ECB starts to buy Italian and Spanish debt (Belgium, anyone?), which no one in Europe is even thinking that the various bailout mechanisms (EFSF, etc.) could handle, which leaves only the ECB to step up to the plate. The ultimate number is quite large.



What Will Germany Do? That has to be the question on the mind of the new ECB president, Mario Draghi, who takes over in November, just in time for the next crisis.

I believe German Chancellor Angela Merkel at her core is a Europhile, and wants to do whatever she can to hold the euro experiment together. But for all that, she is a politician, who knows that losing elections is not a good thing.

And the drum beat of the German Bundesbank and German voters grows ever louder in opposition to the ECB printing euros. Can she explain the need for this to her public?

As my friend George Friedman wrote today, Europe is complex. Speaking about Geithner going to the Eurozone finance meeting this weekend in Poland, he says:

“Geithner’s presence is particularly useful for two reasons. First, despite the vitriol that is a hallmark of American domestic politics, American monetary policy is remarkably collegial.

"The transitions between Treasury secretaries are strikingly smooth. Geithner himself worked for the Federal Reserve before coming into his current job, and Geithner’s partners in managing the US system—the chairmen of the Federal Reserve and the Federal Deposit Insurance Corporation—are typically apolitical. Geithner holds the United States’ institutional knowledge on economic crisis management.

“Second, what Geithner doesn’t know, he can easily and quickly ascertain by calling one of the chairmen mentioned above. This is a somewhat alien concept in Europe, which counts 27 separate banking authorities, 11 different monetary authorities, and at last reckoning some 30 entities with the power to carry out bailout procedures.

“Getting everyone on the same page requires weeks of planning, a conference room of not insignificant size and a small army of assistants and translators, followed by weeks of follow-on negotiations in which parliaments and perhaps even the general populace participate in ratification procedures.

"The last update to the European Union’s bailout program was agreed to July 22, but might not be ready for use before December. In contrast, the key policymakers in the American system can in essence gather at a two-top table for an emergency meeting and have a new policy in place in an hour.

“Geithner will undoubtedly point out that the European system is not capable of surviving the intensifying crisis without dramatic changes. Those changes include, but are hardly limited to, federalizing banking regulation, radically altering the European Central Bank’s charter to grant it the tools necessary to mitigate the crisis, forming an iron fence around the endangered European economies so that they don’t crash everyone else, and above all recapitalizing the European banking sector to the tune of hundreds of billions (if not trillions) of euros—so that when trouble further intensifies, the entire European system doesn’t collapse.”

That is the standard Europhile leader’s line. I talked this week with a leader of that faction, and that could be his speech.

But again, that is not what Germany signed on for. They thought they were getting open markets and an ECB that would behave like the Deutsche Bundesbank. And it did for ten years.

Now, in the midst of crisis, the rest of Europe is talking about needing a less restrictive monetary policy. That means potential inflation, which still strikes fear in the hearts of proper German burghers.

If George is right, Geithner will be speaking to (mostly) a receptive audience. But he is a central banker talking, not a politician. And his message will not play well in Bavaria, or in any country that still thinks of itself as a country, which is to say all of them.

Remember this: In order to get the European treaty passed in France and in the Netherlands, they had to remove the parts about the flag and other symbols of unity. It is still 27 countries in a free trade zone, with different languages.

Bottom line: I think that the end result of lending to the ECB will be to postpone the problem. The problem is not liquidity, it is insolvency and the use of too much leverage by banks and governments. This action only buys time.

And maybe time is what they need to figure out how to go about orderly defaults, which banks and institutions to save and which to let go, which investors will lose, whether some countries must leave the euro, etc.

Frankly, the world needs Europe to get its act together.

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