Thursday, May 12, 2011

A Cold-Eyed View of The ECB Intervention

Despite having occurred over two years ago, there is still quite a bit of denial and misinformation on the federal government bailouts and takeovers of late 2008.

Meanwhile, Europe, through it's central bank, engaged in similar bailouts of publicly-held banks.

Timo Soini, the chairman of the True Finn Party in Finland, recently wrote a Wall Street Journal editorial entitled Why I Don't Support Europe's Bailouts. Soini's party is Finland's left-wing populist party, so it's not surprising that it desires more state-directed economic investment and control. But Soini's sentiments regarding how the ECB's bailouts actually worked is rather refreshing.

Here's what he wrote.

When I had the honor of leading the True Finn Party to electoral victory in April, we made a solemn promise to oppose the bailouts of euro-zone member states. Europe is suffering from the economic gangrene of insolvency—both public and private. Unless we amputate that which cannot be saved, we risk poisoning the whole body.

To understand the real nature and purpose of the bailouts, we first have to understand who really benefits from them.

At the risk of being accused of populism, we'll begin with the obvious: It is not the little guy who benefits. He is being milked and lied to in order to keep the insolvent system running. He is paid less and taxed more to provide the money needed to keep this Ponzi scheme going. Meanwhile, a symbiosis has developed between politicians and banks: Our political leaders borrow ever more money to pay off the banks, which return the favor by lending ever more money back to our governments.

In a true market economy, bad choices get penalized. Instead of accepting losses on unsound investments—which would have led to the probable collapse of some banks—it was decided to transfer the losses to taxpayers via loans, guarantees and opaque constructs such as the European Financial Stability Fund.

The money did not go to help indebted economies. It flowed through the European Central Bank and recipient states to the coffers of big banks and investment funds.

Further contrary to the official wisdom, the recipient states did not want such "help," not this way. The natural option for them was to admit insolvency and let failed private lenders, wherever they were based, eat their losses.

That was not to be. Ireland was forced to take the money. The same happened to Portugal.

Why did the Brussels-Frankfurt extortion racket force these countries to accept the money along with "recovery" plans that would inevitably fail? Because they needed to please the tax-guzzling banks, which might otherwise refuse to turn up at the next Spanish, Belgian, Italian or even French bond auction.

Unfortunately for this financial and political cartel, their plan isn't working. Already under this scheme, Greece, Ireland and Portugal are ruined. They will never be able to save and grow fast enough to pay back the debts with which Brussels has saddled them in the name of saving them.

Setting up the European Stability Mechanism is no solution. It would institutionalize the system of wealth transfers from private citizens to compromised politicians and failed bankers, creating a huge moral hazard and destroying what remains of Europe's competitive banking landscape.

Fortunately, it is not too late to stop the rot. For the banks, we need honest, serious stress tests. Stop the current politically inspired farce. Instead, have parallel assessments done by regulators and independent groups including stakeholders and academics. Trust, but verify.

Insolvent banks and financial institutions must be shut down, purging insolvency from the system. We must restore the market principle of freedom to fail.

If some banks are recapitalized with taxpayer money, taxpayers should get ownership stakes in return, and the entire board should be kicked out. But before any such taxpayer participation can be contemplated, it is essential to first apply big haircuts to bondholders.

For sovereign debt, the freedom to fail is again key. Significant restructuring is needed for genuine recovery. Yes, markets will punish defaulting states, but they are also quick to forgive. Current plans are destroying the real economies of Europe through elevated taxes and transfers of wealth from ordinary families to the coffers of insolvent states and banks. A restructuring that left a country's debt burden at a manageable level and encouraged a return to growth-oriented policies could lead to a swift return to international debt markets.

This is not just about economics. People feel betrayed. In Ireland, the incoming parties to the new government promised to hold senior bondholders responsible, but under pressure they succumbed, leaving their voters with a sense of disenfranchisement. The elites in Brussels have said that Finland must honor its commitments to its European partners, but Brussels is silent on whether national politicians should honor their commitments to their own voters.

Say what one will about Soini's motives, it's clear that the crony capitalism of Europe's ECB, member country governments and large banks make for easy targets of his criticisms. And I don't think his analysis is flawed. In fact, his emphasis on identifying and closing insolvent institutions precisely echoes the comments of Anna Kagan Schwartz from 2008, on which I posted here.

Yes, his critics will claim, as did defenders of Bernanke's actions, that entire economies were at risk without such interventions.

But I don't believe that was ever true. In no case was a failing entity, whether it be Lehman, GM or Goldman Sachs, unable to be placed into Chapter 11, reorganized, and either spun back out or its remnants sold to surviving competitors or new entrants at market-clearing prices.

Soini is correct when he parrots the capitalist line that failed institutions must be allowed to fail and free up resources for others to use. But because, in Europe, an unholy alliance of banks and fiscally-vulnerable bond-issuing governments had developed, taxpayers were soaked to shore up the private, publicly-held financial sector entities.

While the specific mechanics of the ECB bailouts differ from those of the US due to the dollar being the world's current reserve currency, the basics are not dissimilar.

Entrenched managements were able to cash in on existing ties, business networks and fears of financial and economic turbulence in order to, in most cases, with very few exceptions (Bear Stearns, Lehman, AIG, Merrill Lynch, Wachovia) retain control of their companies and proceed to earn lush, post-bailout profits.

Managements like to identify themselves with the assets their companies control, in order to scare politicians into forgetting about Schumpeterian dynamics.

No matter what the event, when companies are found to have been managed badly, and succumb to some environmental or self-inflicted catastrophe, the valuable parts of such enterprises will still be desired and acquired by some other parties. The parts which failed should have been liquidated anyway. In America, there is a Constitutionally-assured method, bankruptcy, for orderly management of such changes in control and liquidations. Just because the Fed, FDIC and Treasury didn't engage in such invasive rescues did not mean that there were not more prudent and limited steps these various government entities could have taken to stabilize the financial sector and avoid economic depression.

Intervention of the sort conducted by the ECB and the Fed only serve to make ordinary voters and taxpayers sceptical of political-business alliances and cronyism. And create fertile ground in which socialists like Soini and the current US administration can flourish.

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