It’s time for a real stress test
By
Bill Bonner Jan 20, 2012
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Last week, Spain and Italy were able to offload €22bn worth of debt. Newspapers reported that calm had returned to the markets. Lenders and borrowers breathed more easily. Bankers put their feet up. Apparently, no major bank in Europe was so far underwater that the European Central Bank (ECB) couldn’t bring it to the surface.
Then, on Friday, credit-rating agency S&P downgraded several European nations’ debt. This brought the debt of Europe’s stabilisation fund, the EFSF, into doubt too. Suddenly, Europe was gurgling again. ECB head Mario Draghi wondered on Tuesday if the ratings had any value. After all, he had given the banks €489bn in December. A lack of cash will no longer bring them to grief. Then, what will? That is, of course, what we will find out.
The ECB is scheduled to relax its bungee collateral requirements. The bank will now lend against used cars and day-old bread. But Draghi suggested that he had no intention of following America’s Federal Reserve in its irresponsible “quantitative easy” path. Instead of buying the bonds directly, he and the banks will collude to defraud the public. The ECB will pretend to be in control. The banks will pretend to be solvent.
The conceit of modern public finance is that people with good political skills can do a better job of deciding which banks are solvent than the marketplace. ‘Raw capitalism’ is just too impulsive, they claim. It makes hasty decisions, often throwing out the baby with the bath water, and the bathtub too. By contrast, wise bureaucrats keep their wits about them, even in a crisis.
The Financial Times is running a series it calls ‘Crisis in Capitalism’. The writers claim capitalism needs adult supervision. Samuel Brittan, for example, says it “requires… the use of monetary and fiscal policy” to keep it doing what it is supposed to do.
What’s that? He thinks he knows. Capitalism is “a means to freedom and prosperity, not an end it itself”. We disagree on both points. Capitalism couldn’t care less whether people are prosperous or poor. As to fiscal and monetary policy: Brittan presumes that the question of whether or not central planning by bureaucrats (using fiscal and monetary policy) actually improves market outcomes is settled.
Last Thursday, the US Federal Reserve helped resolve the doubt we never had. It released records of its internal discussions in 2006, when the US housing and finance bubble was reaching its peak. On the evidence provided, the Feds never had their wits about them, even when the going was good. In The New York Times, we discover that “top Federal Reserve officials marvelled at the desperate antics of home builders seeking to lure buyers.
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The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. They joked about one builder who said that inventory was ‘rising through the roof’.
But the officials, meeting every six weeks to discuss the health of the nation’s economy, gave little credence to the possibility that the faltering housing market would weigh on the broader economy… instead they continued to tell one another throughout 2006 that the greatest danger was inflation – the possibility that the economy would grow too fast.”
While the American authorities couldn’t spot a crisis, the Euro-fixers were actively creating one. Draghi is a veteran of the World Bank, the Italian Treasury, and Goldman Sachs. He was on the job in Rome while Italy was building up the debt it now finds so hard to pay.
Christine Lagarde, now head of the International Monetary Fund, was French finance minister from 2007 to 2010 – when France grew its public debt by about 50%. Dust any financial crime scene from the last 20 years and you will find prints from them and their confrères – the public payroll dunces who now claim to be fixing the system. They are the very same people who brought Europe and the world to the brink of financial disaster. Now they preside over more monetary and fiscal policy tweaks, more controls, more regulations, more ‘stress tests’.
Most likely, the leading financial institutions, as well as most of the sovereign nations of the developed world, are already insolvent. We say “most likely” because neither we nor anyone else can know. Real solvency – like the value of the ECB’s collateral – is not judged by earnest ratings, phoney stress tests, or bureaucrats. It’s determined by the real stress test of the marketplace.
No one ever knows what anything is really worth – especially financial institutions with complex holdings and obscure business models. Not even their owners. It needs to be discovered. How? By real testing. We saw what the banks were worth under the benign credit conditions leading up to 2007.
Then, conditions changed. Under the stress of the market’s new challenge, Bear Stearns and Lehmans buckled. This caused investors to wonder about the rest of them. But instead of allowing the process of price discovery to go on, US authorities stopped the test. What a pity. We don’t know which bank, or nation, is insolvent. Most likely, they all are.
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