United in Ponzi since the Middle Ages

It was in the late middle ages when governments first realized that the practice of fractional reserve banking – at the time rightly regarded as fraudulent –  could be put to very good use for their own goals.

After observing a number of boom-bust sequences in the period a.d. 1300 to a.d. 1500, complete with bank runs in which depositors lost most of their assets, a typical conversation between a politician and a banker in late medieval Spain or Italy may have gone like this:

Politician (mayor, archduke, king…take your pick): „Look, we know what you're doing. You're systematically defrauding your customers. This means (brief interlude: leafs through statute book, at the time still of moderate size…)….lemme see….ah, there it is. Public beheading for you. Some glory for me, for having made an example of the usurious thief we both know you are.”  Pregnant pause. 

Banker: “Aaaand?”

Politician: “Why don't we go into this business together?”


And so the banking cartel was born, the state-capitalistic combine that has been perfected in modern times with the creation of central banks and the adoption of fiat money. Banks were given the privilege of working with fractional reserves and in exchange helped finance the debts of governments. The essential features and the job of this system are still the same today as they were first conceived in late medieval times.  Only, the system has certainly been perfected over time. It has e.g. been learned that stealing too much all at once is not a good method. It's better to boil the frog surreptitiously and slowly. 

Alas, even though the system has been perfected, it can not escape economic laws. This means that in the long term, there will always come the point at which these laws catch up with the shenanigans of banks and governments.

This is the juncture which euro area bankers and governments have now finally reached. It is actually gratifying to see them at each others throats of late – it's a bit like a family feud you might say, a disagreement between different branches of the mafia.


Leverage and Regulations

As our readers know, we are always deeply suspicious of business regulations. It is a demonstrable fact that all of these regulations restrict production. The question is always what the costs and benefits are. As Ludwig von Mises notes in Human Action by way of example, regulations that are put in place to e.g. control fire hazards certainly impose an economic cost. Alas, they can be justified by the consideration that they help prevent potentially far greater losses at a later time.

So the pros and cons of regulations always have to be weighed in this manner:  it is impossible to argue that regulations do not impose economic costs. They always do. The question is only if they help avert even greater losses down the road.

Let us rather say,  that is what should be the question. In reality most regulations are actually designed to create privileges for politically well-connected established groups of producers to the detriment of consumers and society at large.

Regarding the debate over the banks in Europe, it has to be acknowledged that things are what they are: only 5.4% of all money substitutes in the euro area are actually covered. The remaining 94.6% are fiduciary media – claims to money issuable on demand for which no money proper actually exists.

Therefore, contrary to what the bankers claim, the demand that is now on the table, namely that they should at least increase their core tier one capital ratio to 9% of their assets is not an unreasonable demand at all. They are in fact getting off lightly – their leverage will still be enormous once this has been put in place.

The banks are arguing, at first glance not entirely unreasonably, that what lies at the root of their current problems is actually not their fault. After all, so they say, we were told that government bonds are so safe that they require that nothing  be set aside in reserve against them. Governments however have not kept their end of the bargain: they have amassed such large debts and deficits that the capital position of the banks holding these 'absolutely safe' assets has become impaired. Now governments are trying to unfairly heap blame on us, so say the bankers, and impose unnecessary costs.

There is some truth to that assertion, but the bankers are forgetting something: they were playing this game voluntarily, in exchange for the privileges they enjoy. These are privileges that no other branch of business can even dream of. They can create money ex nihilo and profit from lending it out! They are backstopped by a central bank that can and does lend them unlimited amounts of money, likewise created from thin air.

And they have been in bed with governments all along – as noted above, since medieval times in fact.

They are also forgetting that they were instrumental in creating the many housing bubbles all over the world that have eventually turned into the mortgage credit crisis of 2008 – governments then bailed them out and the fiscal position of many governments deteriorated sharply as a consequence (the country where this is most obvious is Ireland).



Money TMS in the form of currency, covered and uncovered money substitutes in the euro area banking system. Uncovered money substitues available on demand amount to nearly €3.7 trillion, as opposed to a mere €211 billion in covered money substitutes  as at September 2011. Data via Michael Pollaro – sorry, no better resolution available.



Hair Gets Cut

In addition to the demand for comprehensive bank recapitalization – a copy of the draft can be found here (pdf) – euro-group heads of state were up until today deadlocked with the banks over the 'Greek haircut' debate. It is quite comical, a 'Kabuki theater', as the WSJ avers.

What's so eminently funny is that although everyone knows for a fact that Greece is as bankrupt as one can possibly be – left to its own devices, it couldn't repay a dime of its debt and creditors would likely have to write off 90% or more of the value of the debt they hold – the 'haircut', regardless of how big it is, must be 'voluntary'. Otherwise it would be considered a 'credit event' (here one must ask: if a 50% or 60% haircut isn't a 'credit event', then what is it?) which would trigger CDS on Greek debt and be classified as an 'official' default.

This in turn would impair the debt now held by bureaucracies such as the ECB and IMF, which have climbed up the ladder of creditor seniority to the very top. This is one of the reasons why existing Greek debt trades so extremely poorly – with ECB and IMF representing the senior creditors that outrank all others, existing Greek debt is practically worth nil. Moreover it is held that an official default would create a much bigger shock to the system than the comical 'voluntary' haircut that the politicians are now forcing the banks to accept.

It's no surprise then that these talks were still not going anywhere as of yesterday. However, as Bloomberg reports, the banks have now 'bowed' to 'Angela Merkel's last word' on how much they will have to write off:

“The world’s biggest banks bowed to what German Chancellor Angela Merkel called the “last word,” agreeing to write down their Greek government debt by half in the pivotal piece of the euro area’s bid to stem the financial crisis.

The Institute of International Finance, which represents financial companies, agreed to “develop a concrete voluntary agreement on the firm basis of a nominal discount of 50 percent on notional Greek debt held by private investors,” Managing Director Charles Dallara said in a statement e-mailed at 4:26 a.m. in Brussels.

Euro-area leaders who called Dallara into a meeting at about midnight, forcing a break in their 10-hour summit, said that while the bond transaction will be voluntary, the decision resulted from an offer he couldn’t refuse.

“It was the fiercely delivered wish by Merkel, Sarkozy, Juncker, that if a voluntary agreement with the banks was not possible, we wouldn’t resist one second to move toward a scenario of the total insolvency of Greece,” Luxembourg Prime Minister Jean-Claude Juncker told reporters. That “would have cost states a lot of money and would have ruined the banks.”


(emphasis added)

Professional bank robbers in the EU might want to take note and perhaps take a leaf out of the politicians' book in the future: put a gun to the head of the bank cashier and let him sign a piece of paper that states that he handed the  money over to you 'voluntarily'. Presto, it can no longer be considered a bank robbery. Instead you have arrived at a voluntary agreement with the bank to relieve it of the burden of having so much money lying around.

It is actually unfortunate that the salutary event of a 'total insolvency of Greece' was avoided in favor of more extend and pretend. Given the bailout-induced structure in creditor seniority, a 50% haircut does almost nothing to help Greece after all.  A few ruined banks? Worse things have happened and last we looked, the world was still turning anyway.

It also emerged that aside from the 50% Greek haircut, the EFSF has now been boosted to € 1 trillion via the previously discussed leveraging schemes. Observant readers may recall that we first heard such gigantic numbers being thrown around well over a year ago, in May of 2010 (back then the EFSF was declared to come into possession of € 750 billion, a complete fantasy number as it turned out).

Overall the outcome is better than we anticipated one week ago,” [say what?, ed.] Laurent Bilke, global head of inflation strategy at Nomura International Plc in London, said in an interview. “There are several issues left open, but I do believe that getting a more necessary debt relief for Greece is a pretty important step.

Last-ditch talks with bank representatives led to the debt- relief accord, in an effort to quarantine Greece and prevent speculation against Italy and France from ravaging the euro zone and wreaking global economic havoc. Greek Prime Minister George Papandreou will address the nation at 8 p.m. in Athens to outline the summit’s ramifications for the country at the eye of the two-year sovereign debt crisis.

“The world’s attention was on these talks,” German Chancellor Angela Merkel told reporters in Brussels at about 4:15 a.m. “We Europeans showed tonight that we reached the right conclusions.”


“It’s long on words, short on detail,” said Peter Dixon, an economist at Commerzbank AG in London. “The solution that’s been put in place now gives us enough ammunition to stave off any immediate problems but we may well run into other problems down the track.”

We find it interesting that Nomura has a 'global head of inflation strategy'. That sounds like an interesting job, very much in keeping with the Zeitgeist. Otherwise we fear we have to agree with Mr. Dixon – the 'long on words, short on detail' accord has done nothing but buy a little bit more time.

In fact we believe now that the 'Greek haircut' is out of the way, the markets will immediately begin to concentrate on the next default candidate, namely Portugal. There may be far less time before the crisis becomes acute again than the eurocrats think. The belief that Greece can be 'ring-fenced' will soon be put to the test. We believe it will once again turn out that it won't be possible to keep all the plates spinning in the air.


No More Airbuses

In their struggle to prevent recapitalization to become too onerous, the bankers now warn of a credit crunch. Again, this is not at all unreasonable – we believe there already is a credit crunch and it is likely going to get worse.

Alas, the question is actually whether this is good or bad. In the short run a credit crunch means that economic activity will come under pressure. All the false economic activities that could only flourish while more and more fiduciary media were thrown on the loanable funds market will wither and die.

Contrary to the superficial impression the associated economic downturn will create, this is actually a good thing. It will free up resources for economically viable activities that actually generate wealth. Life will in fact become easier for those engaged in genuine wealth creation, as the competition for scarce resources from bubble activities will diminish. Their profit margins should accordingly improve.

The bankers meanwhile are threatening euro-land politicians with withdrawing their support from some of the most cherished subsidized white elephants currently emplaced in the EU if they are forced to increase their capital ratios 'too much'. As Bloomberg reports:

A top lobbyist for France’s largest bank says European lawmakers will have only themselves to blame if pressure to bolster capital too quickly results in more Boeing Co. planes at the expense of European rival Airbus SAS.

“In the case of the French banks, activities where they were leaders like aircraft leasing or shipping financing will be partly taken over by U.S. or Chinese banks,” Dominique Graber, co-head of BNP Paribas SA’s public and prudential affairs, told the European parliament’s committee on economic and monetary affairs in Brussels on Oct. 11. “One will also not be surprised if later on more Boeings than Airbuses get funded.”

European banks say they have to cut assets to help satisfy a government push to boost capital faster than planned to insulate them against the sovereign debt crisis. That may trigger a credit crunch for companies and consumers throughout the 17-nation euro zone, helping to push its economy into recession, say Citigroup Inc. and Deutsche Bank AG analysts.

Leaders meet today in Brussels to approve a plan to increase lenders’ capital by about 100 billion euros ($139 billion). Banks say they will more likely achieve the new requirements by shrinking rather than raising cash from shareholders, a scenario they want to avoid partly because their share prices have fallen 30 percent this year.

“Threatening there will be fewer loans for Airbus aircraft is pernicious,” said Christophe Nijdam, an AlphaValue bank analyst in Paris. “Aircraft leasing isn’t a big amount in BNP Paribas’s balance sheet, but imagine the impact of such a comment on German or French lawmakers with an Airbus plant in their constituencies. Banks have other ways to boost capital than reduce lending to businesses. They could cut their trading books for example.”

Banks are using the threat of lower lending to influence talks with regulators, just as demand for financing declines in a slower economy. Lenders reported a net decrease in loan applications by non-financial firms in the third quarter, the first drop in more than a year, according to the European Central Bank.

“This whole tune sounds familiar, and it’s always been the case ahead of major recapitalization exercises that we see these statements of banks,” said Christian Gattiker, head of research at Bank Julius Baer & Co. in Zurich. [he should know, ed.]

Banks are more important to the European economy than they are in the U.S., according Bank of America Corp. economist Laurence Boone. She calculates that loans to the private sector totaled 145 percent of gross domestic product in 2007, more than double that of the U.S., where companies rely more on stock and bond markets for capital. [it is in short high time that they become less important, ed.]

James Ferguson, head of strategy at Arbuthnot Securities Ltd. in London, draws parallels between Europe’s current situation and the credit crunches suffered in recent decades by Japan, the U.S. and the U.K.

“History shows that bank recapitalizations provide the catalyst for the credit crunch,” he said in an Oct. 20 note. “Japan learned this in 1998, and the U.S. and the U.K. in 2008. Continental Europe’s lesson starts now.” 

One can always hope that such a lesson will 'start now'. Alas, thinking about what Mario Draghi said yesterday and reflecting on the personnel changes over recent months at the ECB, we are actually getting the feeling that we are seeing a long-range plan coming to fruition –  a plan that consists of decisively weakening the ECB's monetary conservatism.   As we wrote a little while ago:

“Their [Germany's central bankers] desire to keep monetary policy strictly outside of the realm of fiscal policy has led them to oppose the interventions in government bond markets, and since they were outvoted at the ECB, two of them (Axel Weber and Jürgen Stark) ultimately resigned because they didn't want to be associated with the policy.”

In hindsight we are beginning to think that both men were probably pushed out. Yes, they could not in good conscience support the ECB's decision to throw its treaty obligations and principles overboard – but in all likelihood they were told that in that case, it would be better if they 'voluntarily' removed themselves from the scene (a bit like the 'voluntary haircut'). Jean-Claude Trichet, although misguided about his cherished 'price stability policy', was an 'old school' central banker as well. He appeared extremely reluctant to implement the bond buying strategy and always stressed that he wanted to end it as soon as possible. However, his term was coming to an end anyway – and it may not be a coincidence that the end of his term and the latest euro-group emergency summit coincided timing-wise. Not least because the very first thing Mario Draghi said in his official position as Trichet's successor was that he would indeed continue with the ECB's buying of government bonds in the secondary market.

With regards to the Airbus, don't you worry. We bet we will get to see many more of these ugly birds crash in the future.



New ECB president Mario Draghi:  the job of Nomura's 'head of global inflation strategy' will probably be safe with him.

(Photo via Gigasweb srl)




Want to point readers to an interesting interview with Tom DeMark, inventor of the 'TD sequential system' methodology.  DeMark has recently had a 'hot hand' and made many eerily precise and correct calls on the stock market's future direction and turning points, but one must of course be aware here that 'hot hands' often tend to turn cold once they get a lot of publicity, so take this with a grain of salt.

Still, what we found interesting is that he believes the market's current overall pattern has a lot of similarities with the pattern observed in late 1973:



The S&P 500 in 1973 – Tom DeMark thinks that the October-November 1973 pattern serves as a good analogue to today's stock market pattern.





Charts by: Michael Pollaro, Tom DeMark



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4 Responses to “The Games of Banks and Governments”

  • zerobs:

    It’s like these overspending governments succeeded too well. They set the banks up to be the bad guys and the banks don’t mind bad PR as long as they make their promised billions. But they made these banks toxic.

    But now the banks have such a bad rep that people already would suspect a new bank of being set up specifically to operate just as badly and hope people forget. Well, they will forget, but it will take a little longer for them to forget this time. So they’ve made it hard for new banks to open. And these bad banks are so large they’d need to replace them at a 10:1 ratio for there to be any trust that they won’t get too big too quickly, but that hinders each new bank’s capital attraction. If Bad Bank A is closed and New Bank B opens, only pension funds will be stupid enough to want in. Open New Banks B, C, D, E, F, G, H, J,and K and then maybe you can get people to believe a few of them might actually behave more honestly. Does anyone really have any doubt that Ally Bank is going to behave irresponsibly? I sure don’t.

    There is no way the banks, old or new, are going to make one bit of difference if the governments still require them to operate the same way to run cover for overspending. At best it is just more can kicking and accounting tricks but the structural problem remains 100% unchanged..

    • The entire system would require profound change – from cartelization to free banking based on traditional legal principles and sound money (100% reserve for demand deposits, and a clear distinction between loan and deposit banking).
      Such a free banking system would not need thousands of pages of regulations – the rules governing it could be written down on the back of a napkin.
      Of course this would be a very radical departure from what we have in place now.

  • More of you can’t make this stuff up. Amazing Merkel and others don’t recognize this bluff worked. The governments can go into banks and audit them. They can enforce mark to market instead of fantasy. They can close and declare them insolvent and put them under management and then reissue stock in a new IPO. New paid in capital can only come from the other credits on the bank ledger, so it serves to move bank liabilities to equity. It also reduces the supply of media to pay the rest of the debts owed banks.

    The point I am trying to make is many of these banks don’t have any equity to dilute and that is the problem. They wouldn’t mind issuing more stock if they were selling it like they sell everything else, at an inflated price. But it seems they are only interested in repurchasing their stock at inflated prices and liquidating capital before they lose it and then use the tanks in the street threats to coerce the public to recapitalize them.

    A new IPO, on the other hand, would not be faced with the bureaucratic failed management of the existing bank. There would be no equity to dilute, they would have a solid book of business as long as the deadwood was cleared out and quite possibly, if they wished, a brand name of the old bank. Who would really want to invest in the mark to fantasy business there today? The banks are playing Russian roulette, trying to keep private the fact the aces they are trying to present are actually 2’s and a joker.

    What is being lost in this mess is all this financial arrangement is for already spent money. More capital and credit being pulled down the black hole of inflated government finance. The EFSF, it appears, is going to be used as MBIA or Ambac was used and once the losses come, the underlying debt will not be so attractive. Do these idiots really believe they are going to convince the world a pauper can pay? None of these governments can continue to borrow more money, which they are all having to do, because they are all running deficits, even in austerity and become solvent. If they do, it clearly has to be issued as a senior liability or the market won’t touch it. This will, of course, force the existing debt down the chain and deflate its value. We are watching the proverbial dog run circles trying to catch himself.

    That last point is of great interest, the fact that the aid provided by the ECB and IMF actually destroyed the position of the underlying debt. This likely means these countries become administered by these outfits and their existing bondholders end up eating more than their share of the losses. It means the current bonds of Italy and Spain that aren’t already in this privileged position are likely junk. Also, that the 50% haircut on Greece is the starting point.

    If I owned a CDS on Greece, I would surely be in court if this wasn’t declared a default. What happens in a default other than a negotiated settlement after the dust settles? Have the governments of Europe declared contracts that were bought and paid deficient? If so, then I would suspect a refund of premium would be in order. Consideration has been denied

    • Very well put. And indeed, as I noted today, the failure to declare the Greek haircut a credit event not only smells of an abrogation of contract, but will likely also have considerable follow-on consequences for bond markets.

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