Thank you to the Chicago University Club and the guests – great questions!

Recently, fund managers were actually happy to see finally the rates going down for the PIIGS bonds. Confidence is coming back, they say. Well, I hope they understand that it is the ECB who’s doing the buying (printing) and that overnight, the fiscal situations of these countries have not improved. That should be pretty basic.

The ECB, with Goldmanites Draghi at the helm is making sure everybody understand that he is not directly monetizing the debt of the PIIGS with his LTRO (1%, 3 years loan to banks). This program is making debt issuance (under 3 years) appear “safe”, that is why yields have gone down. At the same time, the ECB balance sheet is growing exponentially? The ECB has added 1 T Euros of junk in 6 months to its balance sheet! That’s more than QE1 by the Fed! We can’t wait to see what happens when Draghi really begin to print!

I remember watching an interview with Olivier Sarkozy (French President’s half brother) of the Carlyle Group (you can’t get more insider than that) saying that the European banks will need at least 3-4 T Euros in recapitalization very short term (2012-2013). It looks like the ECB is well on its way and it also looks like Germany is still ok with printing to save the banking system. Ironically, with this amount of printing, the euro may go down and the European stock market may outperform the S&P! So much for those fund managers above!

France finally lost its AAA rating (and 9 other countries); nothing surprising there if you look at the amount of debt, it is actually surprising that they could keep the rating for that long. So much for the ratings agencies. The downgrades affected more the negotiations with Greece where the private creditors seem to be losing patience. Greece wants more haircuts and private creditors, not so much. Private creditors are resisting taking more than 50% loss on their bonds (what was agreed last Fall). You also have hedge funds that are resisting big time but for other reason: push for a default and cash in on their CDS. Private creditors, we should not forget, means Greek pension funds too. This will not be pleasant for Greeks.

The traditional Keynesian economists continue to throw their hands up in the air and asked for more liquidity to get through this. Remember the drill in ECON 101: deficits during recessions and surplus when all is swell. Well, it never worked that way and it is the reason why we are in this mess. It is still a solvency crisis and not a liquidity crisis. Unlike the “chicken of seas” captain of the Costa Concordia – remember – “the captain always goes down with the ship”, the Keynesians will stay on board and drown in the sea of insolvency.

• Low interest rates fuel capital goods/bubble sectors (housing, internet stocks…)
• Government revenues are inflated (from housing, construction,etc)
• New government spending programs (and we know how those are hard to repealed)
• Bubble burst (credit tightened) – Revenues disappear
• Banking/financial crisis
• Governments step in – save banks, well connected companies (TBTF), new programs
• Result: more government debt / less revenue
• Sovereign Debt Explose
• Government expenditures in the crisis prevent the structure of production to realign (those house builders need to do something else, too much houses=prices must fall)
• Governments socialize the losses and malinvestments
• Sovereign Debt Crisis > Currency Crisis
• Value of fiat currencies rests on governments/central banks
• Balance sheets of central bank deteriorated during the crisis (back the currency)
• Central Banks maintain low interest rate to save the banks and limit bankruptcies
• Government debts continue to grow
• Pressure to print to pay governments’ debt (QEI, QEII, ECB buying bonds, China fuelling its banks)
• Central banks increase base money and see the quality of their assets go down (Greek bonds…)
• Governments in bad shape to recapitalize the banks
• Need more money production
• Governments can default 2 ways:
o 1-Cease payments – banks have a problem – they’re holding bonds – need bailout – feedback loop…
o 2-Inflate away (another form of default)
• Currency crisis:
o Depreciation is masked now as the US and Euro are eroding at the same pace
o You see the depreciation in gold
• Who is paying for the bailouts?
o Holders of US dollars, Euros, Canadian dollars, etc… via loss of purchasing power

So – still want those bailouts?

• Last week, the EC comes up with a bailout plan for Greece; 50% haircut to private creditors and a rescue fund (EFSF) that is “leveraged” from 440B Euros to 1 trillion Euros
• MF Global goes bust having bet on sovereign debt with easy money from the Fed (MF Global is one of the primary dealers authorized to deal directly with the FBNY)
• Wait – that European bailout may no longer be – Greek PM Pappandreaou now wants a referendum on the bailout – the Eurocrats can’t believe it! We want to help you (when I hear that – I usually run in the other directions and that is maybe what the Greeks want to do!) and you want to give “your opinion”! How dare you!

First, we won’t waste too much time on the bailout plan since it is already in jeopardy (!) but let’s just say that “voluntary” haircuts do not exist in the real world but Eurocrats do not live in the real world. The ISDA (International Swaps and Derivatives Association where we find JP Morgan, GS, Barclays, etc.) do not live in the real world either as they accepted the cuts as “voluntary”. Right. Somebody talked to somebody before the bailout announcement – that is for sure. You are to believe that banks will take a 50% haircut and that all will be well? They also forgot to mention that 50% haircuts to private creditors mean Greek pension funds (hold Greek bonds) are cut by 50% too. Many also think that 50% is not enough to bring Greece to viability. Even IMF thinks 60% is more like it. The rescue fund, the EFSF is supposed to be “leveraged” to 1 trillion Euros. It is interesting to see politicians using the same Wall Street methods so vilified during the 2008 crisis. What does leverage means? You don’t have the money. This is why Europeans are begging China to chip in and the IMF and the G20 and why not people on Mars? Why? Because the ECB do not want (at the moment) to print the astonishing load of paper money needed to “fix” this mess. Other people’s money would be best. The Germans are still keeping an eye on that ECB printing press. For how long? That is the question.

Meanwhile, in Greece, PM Pappandreou is maybe trying to pull a fast one on the EU, like his father did (PM of Greece a couple of decades ago) when joining the EC: he would hold his vote to have Portugal and Spain join in so the Eurocrats had to pay him a couple of billions to buy his vote. Greece has a lot to lose but it seems that either way they lose: they will have to cut under the imposed bailouts by the EU or they will have to cut once they are shut out of the market if they default. The difference with the 2nd solution is 1) they decided for themselves, it does not change the facts but maybe the mood; 2) They free themselves from debt slavery to the banksters. But both situations will not be a walk in the park. Eurocrats never liked democracy much as each time they had votes (remember Ireland and France) and people said no, they just went ahead anyway. So it will be interesting what they will do with this one (if there is one because maybe Pappandreou will get what he wants…).

Join at the hip with the sovereign debt situation in Europe just described is 200 years old MF Global going bust this week. MF Global headed by Jon Corzine, formerly of Goldman Sachs and former governor of New Jersey (just that should tell you something!), bet the house on European bonds thinking that countries would be easily bailed out. This is what happens when you can play casino with easy money from the Fed. By the way, MF Global is a primary dealer dealing directly with the Federal Bank of New York and the latter did not see anything going on? The FBNY just announced the day before the bankruptcy that they had stopped dealing with MF Global. It reminds me of LTCM when they blew up in the 1990s betting the house on the Russian ruble thinking the Russians would pay. Greenspan saved LTCM though – but I doubt Corzine will have trouble finding another job – US Secretary of the Treasury would be ideal and is maybe next on his list. MF Global, in a classic move, used client’s money (which is supposed to be in a separate account) in the last week to bet again thinking they would cover their loss. If this is not the typical casino player mentality, I don’t know what is. The other interesting thing is that while many think that there is no real risk of contagion in the US/Canada of exposure to European debt, this is nothing to inspire confidence. The indirect exposure is even more worrying as ones of the biggest investors in MF Global were Fidelity Investments and Guardian Life Insurance – not really your hard core risky hedge fund. “Ordinary” people are more exposed than they think because of all those cross-investments in other funds that are exposed.

Easy money really makes people stupid. And the Darwin Award goes to…

Not too long ago, those same politicians were blasting Wall Street for the “leverage” and the SPIV (Special Purpose Investment Vehicle – Enron got famous with those) which were the hallmark of the mortgage industry in the years leading to the crisis. Now those same politicians want to use “leverage” to try to rescue the Euro! Well, who doesn’t like leverage? Until it blows up in your face.

Leverage is simple – it just says you don’t have the money. But in this case, it is MBS all over again because in turning the EFSF into an insurer of sovereign bonds – we know how those bonds are worth! There are issued by the same countries that are shot out of the market. They think the market will buy those bonds? Well they may find some hopefull s*?*&?&* but I would not bet on many. Also, leveraging the EFSF, as we have mentioned before, put the AAA rating of the said rescue fund and also of France in jeopardy. The spread between the German bonds and the French bonds is at a record high of 1.20% – showing the leverage possibility.

Now, we know who backs the “insurance” – there is only one player – Germany. If you feel we’re back to square one, you’re right. This is what European leaders are supposed to agree on at their Wednesday meeting (if it’s not postponed!). What part of “THERE IS NO MONEY (UNLESS THEY PRINT) THEY DON”T UNDERSTAND?”

Germany does not want to print because they would have done so already (they are the ECB). Between price stability (Weimar 1923!) and currency appreciation – it seems the Germans could easily live with a strong DM as they have in the past. BMW does not compete on prices. In a response to a FT article entitled “Germany will never leave the Eurozone”, very connected Dr. Pippa Malmgren, was indicating on her site (www.pippamalmgren.com)

“The European project will move forward much more robustly once everyone finally realizes that the Euro in its current format is unworkable. Nothing stops Europe from moving forward other than public opinion. The fact is that Germany’s social contract is very different from the social contract between the citizens and the state in any of the peripheral countries. What is required to satisfy Germany brings riots in southern capitals. What is required in Southern capitals breaks the social contract in Germany. The failure of the Euro will bring this conflict into sharper focus and set the stage for new commitments to create a Europe that can satisfy the needs of the members without destroying civil society in Europe”.

We are looking forward to more meetings.

So what is a central banker to do? Operation Twist? Buying longer term bonds, reducing the yield curve by .oooo5%? Won’t do much in reality. More money to save Europe, as weakness is clearly felt from that side of the Atlantic? Maybe. QE2 was, after all, a life line to European banks anyway. It would only be the same story unfolding.

As you may have notice, the Fed is feeling more pressured now, ironically to do less, or stop doing something, than ever before. Hey even the Republicans wrote to the Chairman Bernanke asking him to “stop whatever it’s doing ‘cause it sure ain’t workin’”. It is indeed harder to hide the fact that after 3 years of money pumping and rescuing, the economy is still in the dumps. What? The mortgage rates have never been so low and still people are not buying houses? Damn. Well, how about real unemployment at 20%, do you think that could have anything to do with it? Or that banks don’t really want to lend to a deadbeat who may lose his jobs because – guess what – we’re back to square one – this “non performing” loan will be transferred on Uncle Sam’s balance sheet in a NY minute. The media is disappointed by the latest numbers on the US housing starts (weak or inexistent). Well isn’t that weird, there is overcapacity of one good (houses) and the producers stop producing it, who can believe it? They did not get the memo from the central planners?

But I would not let these details get in the way of more easing. It will be termed differently but they will try all their mighty to save the banks, in this case, the European banks. It doesn’t mean it will work, but they will try, since the US taxpayer does not seem to mind, for now. Also, on the effectiveness of liquidity injecting – we can have our doubts – as last week coordinated intervention by 5 central banks showed: they lent massive amount of US dollars to these troubled European banks and the effect lasted a couple of days. Their stocks went south soon after. Well if 5 central banks can make it work… wait a minute… as our Keynesians friends are fond of saying: it was probably not enough! Mr. Bernanke, get that printing press in overdrive!

Modern Bank Runs
The traditional way to look at bank runs is a line of people outside banks waiting to get their money out of there. Today it’s less graphic. It’s done by computers. A simple email will do: “please wire our funds to X institution, Thank You”. That is how the dominos start because that bank needs to write a similar email to get access to funds. In the last days, we saw a couple of multinationals withdrawing generous amounts from French banks and China even stopped its Forex swaps with European banks. Not a good sign.

Papering over a solvency problem is a very bad idea but this is the path chosen since 2008. Until liquidation occurs, we are in for a wild ride. Very good for speculators though because politicians will continue this nonsense and distort the markets – that’s when you can take advantage of it – but if you are positioned “stocks are for the long term or it’s a buy buy buy”… you may want to grab that bottle of liquor (hey governments allow us to drink now – how sweet of them – they just tax the hell out of it but hey – we should always be thankful to our overlords like good slaves) before you open those statements.

But you see, like so many people who can’t think straight about the role of the state and freedom, they still believe in the “government benevolent role”. It is just a matter of getting the bureaucracies to work better (the Toyota way in public health care!). They think it is just a question of tweaking it, hire the right people, the right leader, the right this or that. Yes, more money from the miners will shorten the waiting times in hospital and increase the number of doctors. Go on and believe that.

When you tell them that the problem is the government being in many areas where it should not be – they think you are an extremist who eat little children for breakfast. The subject of the day here in Quebec is corruption. Yes, corruption in the wonderful world of construction. You see it is very simple; corruption goes hand in hand with government interventions. No government involved in roads and infrastructures – nobody to corrupt. The report that leaked yesterday on the fact that construction and engineering firms go heavy on the extras to recycle those funds into electoral campaigns had all the commentators very excited. They are shocked and again blast ministers and bureaucrats for being such naughty people, that “something” should be done, etc. This looks strange to me because this is the equivalent of asking Al Capone why he doesn’t go and get a decent job and stop killing people. Electoral campaigns each 4-5 years are expensive you know and democracies are, like financial newsletter veteran Doug Casey likes to say, “Mob rules in sport jackets”.

Fiddling with bureaucracies is like rearranging chairs on the Titanic.

1. The debt ceiling talks between the Democrats and the Republicans were never about cutting the existing budget but cutting (maybe) future spending. Will it be 1.8T$ or 1.85T$ of new money they don’t have? Yes the Tea Partiers talk about cutting the budget like you an I think about cutting a budget but then again – we are calling them the t… word.

2. The US downgrade by Standard & Poors. While pondering on this move – let’s not forget the following: the ratings agencies are under the government regulations agencies, the debtors pay for the ratings (the creditors used to pay for the ratings before the SEC came in in 1975…), they are always late to the party, since government agencies oversee the whole thing – they can change the rules for the AAA ratings in investment portfolio – AAA is the same as AA+ – there – it’s simple. When I hear the spin given by Washington on this downgrade – they might actually use it to force this “super congress” to hike taxes – what Obama did not get in the previous deal – invoking that if they don’t have a “balance approach” – the US will suffer further downgrade, blah, blah…. It is also a good excuse to launch the President’s pet program – a major public works program under the name of the National Infrastructure Bank. There would be enough in there for the unions and the bankers.

3. The market “crash” – it seems that without major support by the Fed this market is no good. That goes for the economy as well – as you can see – a slowdown in the propping up rate and everything goes! That is going to continue – up and down – because the “recovery” is not really one – it is based on funny money and more debt.

Let’s not forget Europe where the printing press is finaly on as the ECB had to step in and buy Italian and Spanish bonds to rescue the banks – euh sorry – the PIIGS.

Many of our Keynesians friends think the solution is still more printing and more borrowing and that it is not a good time to cut because the economy, you know, is too weak. It has been 70 years of this experiment and look where it got us. I was re-reading Murray Rothbard’s great book The Great Depression on his account of what really went on during those years (and the years leading to the GP) – and it is amazing – they are using the same playbook: public works agitation; hiking taxes and tariffs, fixing wages, etc. The misery lasted a decade.

But Greece needs more money still. That could be a bit trickier as Germans need to pitch in big time. Ironically, a German economist, Stefan Homburg, bought Greek bonds based on “the endless stupidity of the German government that will bailout Greece and the others”. One year loan paying 25% is a good deal. Yes indeed. That is also how the banks and other hedge fund managers see it for now. And they will move to the next country, pocketing those good deals if they can. In the words of Mr. Homburg: “If no banks are allowed to go bankrupt because it might precipitate a crisis than we’re finished”. Indeed, we are.

The simple fact that national governments seem to be ok with bailing out bankers and indebted countries endlessly shows that the light at the end of the tunnel is a train. In the case of the euro, prepare yourself for the guilt trip that will be served to Germany: if the euro collapses – it will be your fault. But wait? This is actually an OP-ED in Der Spiegel today that states just that. It is argued that Germany, the only sound economy in the aftermath of the 2008 crisis, should have given gigantic amount of money to poor neighbours and help built more powerful European institutions, akin to the US after WWII. Well the EU gave them a powerful currency and tons of subsidies. Guess that did not worked out so well did it? No, as a typical Keynesian socialist, it just wasn’t enough.

The euro is a bad idea but bad ideas die hard as you know. Greece would have been in the headlines if it would have defaulted (again) but not more than Argentina in 2002. Not the end of the world. The enamoured crowd with the euro can’t understand that it was written in the sky that such an experiment was a disaster waiting to happen because it creates moral hazard and violates private property rights on a massive scale.

People Happy to Pay Taxes (PHPT), i.e. us, are appalled to hear that Greeks are not paying their “fair share” and that they evade paying taxes. This is surely, they think, why they have so many problems. They are not “good citizens”. They don’t pay taxes because government is everywhere, if you want to do something, you need to pay a bribe to the government officials (don’t think it is not going on in your beloved country either). In this environment why would you pay taxes on top of that? Remove the government in their lives and you have solved the corruption and taxes issues.

Greece may vote on austerity measures which include, among other things, raising taxes. But raising taxes on what? As reported by Der Spiegel, a successful Greek engineering firm, JEPA, who had worked in projects in London and in Greece (hotels, banks, etc.), did 97% of its business with the private sector. Since the Greek government started having problems paying its bills, JEPA’s business is down 95%. As JEPA’s president is saying: “And now the government, as so often in the 30 years, is making a terrible mistake. Instead of shrinking the public sector, it is raising taxes”. This is a reminder to our own politicians and population: your typical reflex of raising taxes and preserving the public sector? Your model is Greece. Brillant. Keep going.

Now Greece is in the hole to the tune of 350 B euros and the banks and the ECB are on the hook for the bad debt that won’t get repaid. Notice that the ECB was forbidden (by the Maastricht Treaty) to buy government bonds but what good is a treaty if it’s not going to be thrown out the window by politicians at the first sign of trouble. Not repaid you say? Of course not – only in debased euros it will. Besides the fact that 350 B euros is a lot of money for a tiny country like Greece with no industrial base – Greece has its own definition of cuts and consolidation and it’s not exactly the same as the EU and IMF. As stated by Der Spiegel:

“Here’s how it works: OSE, the national railroad, was expected to eliminate its annual deficit of 1-2 B euros by slashing about 1 800 of its 5 800 jobs. But, as in other government-owned businesses, the employees were not let go but transferred to new jobs instead – albeit with reduced pay”

This is consolidation – Greek style.

If you think 110 B euros in bailout (those are loans by the way) last year was a lot of money, Greece needs more than that going forward as there are debt maturities coming due soon in 2013 and 2014 for a nice sum of more of 160 B euros. So going back on the markets for financing in 2012 (what the EU and IMF thought) is out of the question. That means endless bailouts.

The markets if you notice had already figured it out – Greece is insolvent – but S&P yesterday apparently came to the same conclusion and downgraded Greece to CCC from B – only Ecuador is rated worst in term of sovereign risk.

Of course the eurocrats and the architects of the EU do not want to hear the word “default”. Now you have Germany who is putting pressure on private creditors to take some cuts in exchange for further aid. Trichet at the ECB does not want to hear any of it – after all he is sitting on 100 B euros of bad Greek debt himself. One big happy family.

The fact of the matter is there is no easy way out of this. Borrowers borrowed money they can’t repay and lenders lent money that won’t get repaid. Simple. Better take your losses now and move on instead on digging a bigger hole. If they don’t want to face those facts they better start cranking that printing press.