Eurozone Debt, Money, Capital, and Naked Emperors

Thinking Things Over              October 28, 2011

Volume I, Number 15:  Eurozone Debt, Money, Capital, and Naked Emperors

By John L. Chapman, Ph.D.                                                                                                                         Washington, D.C.

In reviewing the details of the Greek bailout/Eurozone debt “deal” hammered out early Thursday morning alongside the Federal Reserve Board’s likely meeting agenda for next week, two books, written a century apart and classics in their respective fields, came to mind: Hans Christian Andersen’s The Emperor’s New Clothes (Copenhagen, 1837), and John Maynard Keynes’ General Theory of Employment, Interest, and Money (London, 1936).  And disturbingly, these two famous works are conjoined in the interstices of Fed and European Central Bank (ECB)/Eurozone policy-making at the moment because the latter book is, in some respects, an echo of the former.  Understanding the link will help to make sense of this week, and what is to come in the next.

Andersen’s Emperor, it will be recalled, was a vainglorious potentate overly consumed with self-flattery (not unlike many modern politicians).  Particularly indulgent over fine clothing, he was tricked into a public appearance being fully naked, duped into thinking he had been privileged with some highly unique and rare cloth.  His subjects, not wanting to insult their sovereign, extolled proper though fraudulent admiration for the supposed magical cloth that made this fine garment.  Finally, it took a young child to exclaim what was plainly the truth: the emperor was naked, and making a fool of himself.  As a brilliant writer of children’s fables that contained morals useful for instruction, Andersen offered a story that contains multiple obvious lessons, and is still a classic 175 years later.

And one of the fore-warnings from this famous tale applies both to the Eurozone/Greek ”deal” as well as to the considerable pontifications contained in Mr. Keynes’ book: Things are not always as they seem.  In the case of the debt “deal” — and intellectual honesty impels us to use quotation marks so as not to bastardize the plain meaning of the English language, we arose Thursday morning to news of “resolution” for the Greeks, promised financial stability in the EU banking system, and consequent soaring equity markets.  But a closer examination of the “deal” leaves any honest broker asking, as did Andersen’s young boy, “Where are the clothes?”

For it turns out that this “deal” is nothing more than a rough outline of something to be worked out in the near future, with more meetings.  Indeed, all that has been agreed to at the moment is that Eurozone banks agreed to take a “voluntary” 50% write-down on Greek debt, raise Tier 1 equity capital to ensure it is 9% of total assets, and participate in a new round of $175 billion in loans to Greece by year end and other EU countries if need be (alongside EU and IMF funds).  The EU and IMF also agreed to raise the borrowing capacity of the European Financial Stability Facility (EFSF) in order to lever the current $350 billion up to $1.4 trillion if need be, and to offer both bond insurance (credit enhancement) and special purpose financing vehicles as needed on a case-by-case basis, to ensure liquidity for EU sovereign debt.

In other words, this “deal” is hardly settled or, as per an old idiom, “not worth the paper it is printed on.”  For one thing, it is telling that all descriptions of the “agreement” took pains to refer to the troubled banks who agreed to accept 50% write-downs as the “private-sector” holders of debt — this is in sharp contradistinction to all holders of Greek debt.  In other words, sovereign holders of Greek obligations (such as the ECB itself or other foreign governments, as well as public sector agencies and government-sector pension funds in Greece itself) have so far not been included in the calculus for write-downs and debt reconfiguration.  But of course this is absurd and will not stand: Greece’s public debt load now stands at $500 billion and is growing.  No better summation of the state of Greece’s public fisc can be found than to observe the yield chart on its two-year bond, which now stands at 78%.  And it is telling that Italian government bond auctions went poorly on Friday, with its ten-year note rising above 6%.  Equally troubling, credit default swaps on French, Italian, and Greek government debt traded higher Friday in pricing in current risk levels post-”deal” announcement.

The other thing to note is that the supposed “firewall” backstop facility of the EFSF, leveraged up to the tune of $1.4 trillion, is still mysterious in at least three ways this weekend:

  • How will the first-portion loss (supposedly to be around 10%) insurance against bond defaults work?  And will it really work in the event of write-downs and defaults where >50% value is eviscerated?
  • How exactly will the backstop (bail-out) program work?  Private capital markets are increasingly wary of Greek, Italian, Spanish, Portuguese, and even French debt — this fear can only increase in the event of a Eurozone recession, all the more likely after 0.2% GDP growth in the third quarter.
  • Who exactly will invest in the EFSF?  If private capital markets are unwilling to either invest or lend directly into either EU banks or EU sovereign government obligations, why would they capitalize the EFSF?  Bluntly, will American tax-payers, perhaps through the Federal Reserve, be asked to participate?

All of this gives rise to our concern about naked emperors on the loose this past week.  Bluntly, closer analysis of what transpired leads to the conclusion that nothing really was settled, and global equity markets rallied thanks to a false euphoria Thursday and into Friday — look for a correction sell-off fairly quickly.  And, for the Greeks, a resumption soon of their long torpor, which is going to end badly thanks to continuing political ineptitude.

Meanwhile, the graphic below, from STRATFOR, depicts accurately what is likely to flow forth from this week’s EU deliberations:

Figure I.  STRATFOR’s Assessment of Likely Outcomes in EU Deliberations Over Greece 

In other words, nothing really has changed in the last week, and the Eurozone is in deep trouble.  Which leads us to think forward to next week for a minute: what will the Federal Reserve do, and what should they do?

Alas, there will be naked emperors running wild at 20th and Constitution Avenue next week too, we fear.  Recent statements by Fed Vice Chair Janet Yellen, Boston Fed head Eric Rosengren, and  the Chicago Fed’s Charles Evans have all hinted directly at a “QE3″ monetary easing under serious consideration, to aid in alleviating the trenchant high unemployment problem in the U.S. – and the Federal Reserve Board’s comprehensive statement after their last meeting, normally oblique, very directly telegraphed the inflationist leaning of Mr. Bernanke.   This is of course a policy preference taken straight from the hallowed pages of Keynes’ General Theory, but is an answer in search of a problem.  For one of the most egregious of many serious theoretical errors in Keynes that have been transposed into bad real-world policy is the notion that the creation of Fed “credit-money” — or as is said colloquially, “running the printing presses” in new money creation — can engender sustainable growth in incomes and employment.  For if that were true, then “money” — the medium of exchange in an economy based on exchange — would be tantamount to “capital”, the collective set of assets such as tools, machinery, and buildings that produce income.

Obviously, there is a type of capital that, in the form of liquid savings, is in a financial form and may reside on the asset side of a balance sheet alongside these other physical (capital) assets.  This financial capital may be in the form of equities or bonds, which themselves represent claims on cash flow from other physical or corporate assets, or it may be in the form of cash, which represents a bearer claim on any asset — including capital assets —  offered in an open market.  And indeed, this is where Keynes made his mistake: in the General Theory he ridicules the notion that interest rates need be regulated by market forces which governed the exchange of present and future goods and involved transfers of claims on capital goods.  He asserted that the government, in the form of a central bank, could regulate interest rates and essentially make them permanently ”low” – and that this would thus eliminate what Keynes held was a false scarcity of capital.   Keynes even bragged in 1943 that his theory’s policy outcome was nothing short of turning stones into bread (no one ever accused Keynes of a problem with his self-esteem).

This is the greatest error in 20th century economics, and represents a tragedy for humanity far beyond many other naked emperors that are encountered in daily life.  For of course it is preposterous to conflate the medium of exchange, which is a claim on an asset, with a real income-producing asset: the laws of economics cannot be annulled.  And in this case, they require saving to accumulate the necessary capital in the form of factories, machinery, software, jet aircraft, and an infinite array of other goods and property that in turn produces real wealth in the form of consumption goods.  To think otherwise, as many inside the Fed very evidently do, is sadly just another example of an unclothed emperor — it is just not so.

Instead, the Fed’s money creation, to the extent the newly-created funds get channelled into the economy through the banking system, merely pulls resources away from one sector of the economy and transfers them to another (the easiest recent example making this point would be the overbuilding of housing in the last decade, which ex post facto is now clearly seen to be representative of massive waste and misallocation of scarce resources in the U.S. economy — many of which resources are now idle as a result, including those of the human variety).  This gross error of intervention by the Fed, repeated many times across its history but especially in the years since there has been no restraint on it in the form of gold, has itself generated the monetary instability that is the source of repeated boom-and-bust.

Marvin Goodfriend of Carnegie-Mellon University, formerly of the Richmond Fed and now a member of the Shadow Open Market Committee, has issued a timely warning to Mr. Bernanke heading into the Fed meeting this coming week.  With a $2.7 trillion Fed balance sheet already triple its size of three years ago, 2.5% GDP growth last quarter, nine quarters of growth, two million new jobs in the last 20 months, and consumer inflation at 4% in the last year, there is no need for another “emergency” monetary stimulus in the form of QE3.  The Fed will only be compounding recent errors if it heads down the path to more easing, with potentially very harsh consequences for all of us later this decade.

Keynesian emperors can’t be clothed over night, alas, but already for this lifetime, the Fed has done enough damage based on a theory that can only exist in a fairy tale.  At least the ones Hans Christian Andersen wrote so long ago caused no real harm.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at

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2 Responses to Eurozone Debt, Money, Capital, and Naked Emperors
  1. It is a genuine pleasure to read the economic and capital market’s weekly analysis, observations and insight which Chapman, Calhoun and Gomez provide.
    You gentlemen are truly top notch and your writings and reports are on par with the best financial markets and economics analysts.

    • John L. Chapman
      November 1, 2011 at 3:51 pm

      Sir, we appreciate very much your saying this, and your interest in our business! Investment management is a very challenging profession, but one thing I can assert with certainty: the entire Alhambra team are all very passionately committed to excellence in the study of markets and the economy as a general matter, and this in turn leads to very good decison-making about asset deployment over time. Very likely we are in for some challenging years ahead but we take it as our mission to keep well ahead of things on behalf of clients. Thanks again for your support.

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