Want to Ruin Your Own Country? Assume Your Banks' Liabilities

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Recently, I read up on how Iceland is doing—surprisingly well, actually. Unemployment is down, the Krona is going back up. Good balance of trade, good fiscal balance sheet. Quite the turnaround, after its troubles over the last couple of years—

—so then if Iceland is doing OK, why then are we in the hole that we’re in?

imageWhy is the American economy slogging along? Why is Europe circling the drain? Why are the bond markets queasy as a patient with a low-grade malarial fever? Why is Ben Bernanke’s chin quivering and his voice quaking on 60 Minutes? (And by the way: Was that a terrifying spectacle or what?) Why has the conversation turned from bond market risk to sovereign debt risk? Why are commodities rising, equities moving jagged and irrational, and all of a sudden silver is now the new darling of the retail investor?

What the hell is going on? Why are things getting worse, instead of better?

The answer is so simple, it hurts:

When the Global Financial Crisis hit in late 2008, the governments took over the liabilities of the financial sector—and in the two years since that terrible, terrible decision, that single move has turned what was once a problem of financial sector insolvency into a problem of sovereign nation insolvency: 

Europe and America are insolvent—they’re broke. They cannot pay the liabilities they have assumed.

That’s why we’re in the trouble we’re in. That’s why Ben Bernanke is crying himself to sleep every night. That’s why the world’s economies are slowly circling the drain—

—remember what happened, in the fall of 2008?

The Federal government bailed out the banks with the famed—not to say infamous—TARP: The Troubled Asset Relief Program, a $700 billion bailout of the banks by any other name.

For its part, in order to “save the financial sector”, the Federal Reserve expanded its balance sheet—that is, it printed money—to the tune of $3 trillion dollars, between Quantitative Easing in ‘08-‘09, QE-lite in early ‘10, and now QE2.

The Europeans made the same mistake as the Americans: They tried to save their banking system. They tried to get through the Global Financial Crisis without any pain.

The Germans bailed out their Landesbank, the UK took over Northern Rock. The Irish bankrolled Allied and Bank of Ireland, the Spanish propped up BBVA—in short, the European governments all assumed responsibility for all their failed banks. They all pretended that it was a liquidity crunch, when it was clearly a banking insolvency crisis.

They’re all paying for this sin today. We’re all paying for this sin today: The inherent instability in all of the markets today is a product of this decision back in 2008—the decision to socialize the financial sector’s losses, instead of letting the insolvent institutions fail.

That the Europeans would socialize the losses is understandable—they’re all a bunch of Socialist pinko-proto-Commie Euro-weenie fellow-travelling Reds: The children of Lenin and Mao, first cousins of Che and Fidel.

But America—what happened in America—land of the free, home of the brave—home of the creative destruction that is the lynchpin of capitalism?

In a word: Capitalism was short-circuited.

See, a bond is a loan—and what’s the underlying risk of lending money? That it won’t be paid back. The interest on a loan is supposed to represent the time-value of the money, plus the risk that the money will not be repaid.

Bond holders of all stripes were supposed to know this—that there was a chance that they would lose the money that they had lent out.

In the run-up to the Crisis in 2008, banks had lent money to dodgy investments—those investments in real estate and whatnot went sour in 2007 and ‘08—boom!: The banks had a loss on their bond portfolio.

The banks’ loss meant that they would default on other loans, to other creditors—usually other banks. So this round-robin of collapsing debt would affect all the banks—

—the banks that had been prudent would suffer losses on these bad loans—but they would likely survive. (Notice how none of the private banks of Europe got into any trouble? Like I said, prudent.)

—but the banks which had been imprudent? The ones which had over-extended themselves? Like all the big banks in America?

They would fail.

So they weren’t allowed to fail.

In 2008, the rationale was, If the banks are allowed to fail—then the entire U.S. economy will die! That was Hank Paulson’s dire warning, when he got on one knee in front of Speaker of the House Nancy Pelosi, and begged her for $700 billion for TARP—with no strings attached—in order to bail out the banks.

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About Gonzalo Lira