Sunday, 30 October 2011

Markets up 20% in a month - what just happened?

Those surprised by the financial markets' incredibly positive response to the EFSF expansion to $1.4 TN may find Doug Noland's piece about Money and the European Credit Crisis quite helpful in understanding what just happened.

Writing about the historical "preciousness" of money, Doug explains how our financial system creates money. Using an array of financial innovations it "monetizes" any sound financial claim by lending bank deposits against it. This creates an artificial demand for these credits and ensures that sound financial claims are highly liquid and thus, as good as "Money."

2008: Questioning "Moneyness"

The credit bubble leading up to 2008 crisis was fuelled by “monetization” of sub-prime mortgage credits through the securitization machinery. The soundness of the resulting derivatives was underpinned by (questionable) credit ratings. Using cheap CDS insurance from AIG, banks could provide liquidity in the secondary market. 

When the securities were revealed to be unsound, they became highly illiquid and lost their “moneyness”. This threatened to bring down AIG and the banks that depended on the unsound insurance provided by an undercapitalised insurer based on fantasy ratings.

The markets enjoyed an incredible windfall since 2009 as Treasury and Federal Reserve backing has restored "moneyness" to Trillions of suspect financial claims. Massive federal debt issuance and Federal Reserve monetization have reflated asset markets and sustained the maladjusted U.S. economic structure.

A Closer Look at Sovereigns

The end of the credit binge caused a painful slowdown in liquidity-fuelled global growth, exposing fundamentally unsound sovereign credits. Governments such as Dubai - dependent on tax revenues from the bubble economy - were bailout out by rich cousins. Those hopelessly in debt, such as Iceland, simply collapsed. Those that weren't permitted to collapse, such as Ireland, were drip-fed financing and their people condemned to debt slavery.

The 2008 crisis has brought forward the Global Government Finance Bubble by several years.

Essentially, the European crisis is about the escalating risk that the entire region's debt could lose its "moneyness." Ever since the introduction of the euro, the European financial system has had an insatiable appetite for Euro-government credits. Under the Euro system European Banks were incentivised to lie to themselves. Euro governments were believed to be fundamentally sound despite unsustainable deficits, and despite explicit EMU treaty prohibitions against bailouts. Core European governments and the ECB would, the banks told themselves, back all government and banking system obligations. 

Many expected that German politicians to calculate that it will cost less to backstop the region's debt than to risk a collapse of European monetary integration. The Germans, however, appreciate like few other societies the critical role that stable money and Credit play in all things economic and social. So far, they have refused the type of open-ended commitments necessary for the marketplace to again trust the Credit issued by the profligate European borrowers, and have insisted that the incredibly bloated banking system eat the losses on Greek debt.

The Franco-Italian Connection 

Increasingly, the consequences of a loss of "moneyness" at the periphery have weighed heavily upon the European banking system. Greece, Portugal and Ireland are just a side-show. Faltering confidence in Italian debt is the real issue. An Italian default will devastate French banks. At the same time, any meaningful French participation in PIIGS bailouts would see France lose its AAA rating. 

The above French conundrum risked impairing the "moneyness" of French Credit,
which is at the core of the European debt structure. This is why the Germans have permitted EFSF leverage up to $1.4 trillion.

The grand plan is to allow IMF/BRIC/Japan/Sovereign Wealth investors to backstop the "moneyness" of European debt, thus providing the bazooka that will ensure market confidence in European Credit generally. For now, the markets are assured that the near-term implosion risk is off the table, which set the stage for a huge short squeeze and destabilizing unwind of hedges across virtually all markets. There may be grand plans and grand designs for a credible "ring-fence," but the critical issue of how to ensure ongoing Italian debt "moneyness" continues to prove elusive.

Haircuts and Inflation

Clearly, the world has too much debt to pay off honestly. Most of it will either be defaulted on, or inflated away. There will be repeated crises of confidence as the soundness of credit after credit is called into question and ultimately "demonetized". 

Inflation, where possible, will steal from savers. It will have to be executed carefully, as any rapid loss of value can lead to capital fright, resulting in a loss of confidence in the inflated currency. Witness the masters of propaganda at the Bank of England employ deflationist scare tactics to cloak the effects of their QE-fuelled inflation, which runs rampant in the UK.

As the crisis inexorably grinds from the periphery to the core of the global financial system, the dominos will fall one by one. US treasury bears will have to be very patient. There is plenty of drama to sit through before the final act - demonetization of US credit - is played out. Meanwhile the dollar devaluation will continue in a volatile downtrend.

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