by
Gary North
Tea Party Economist

Recently
by Gary North: Tariffs
as Welfare State Economics

For the first
time in my career, I see the international establishment, sometimes
called the New World Order, facing a crisis so large that its very
survival is at stake. For the first time, these people are scared.

There are
not many of them. In his book, Superclass,
author David Rothkopf estimates that there are only about 6000 people
at the top of the pyramid of world power and influence. They are
mostly males, and at least a third of them have attended America’s
most prestigious universities. Most of the others have attended
comparable universities in Europe.

The crisis
in Europe is clearly beyond anything that this generation of establishment
leaders has ever seen. The last time that anything like this faced
the European establishment, it led to World War II.

During the
entire postwar period, the United States has been the dominant force
in the West. The United States government through the Marshall Plan
wrote the checks to keep the European governments afloat, and it
funded most of NATO, the mutual defense system that was set up to
constrain the expansion of the Soviet Union.

The United
States is no longer in a position to bail out anybody. It is running
a massive trade deficit, and is running a massive federal deficit.
Europe realizes now that, from an economic standpoint, it is on
its own. If there are solutions to the European economic crisis,
these solutions are going to have to be generated inside the eurozone.

BANKS
AT RISK

Today, the
entire banking system of Europe is at risk. The banks are highly
leveraged, and they have made enormous investments at low-interest
rates in bonds issued by governments that are technically insolvent.
There is no possibility that any of these bonds will ever be repaid.
They were never designed to be repaid. They were designed to keep
the taxpayers of all European countries in permanent bondage to
the banking system.

Now, in a
complete reversal of fortune, the banks are increasingly dependent
on the governments. The governments are now the lenders of next-to-last
resort to the commercial banks. The central bank, of course, is
the lender of last resort. But today, the European Central Bank
has moved into neutral. It does not want to take action to bail
out Greece, Spain, or Italy.

The PIIGS
governments that wrote the IOUs to the banks in northern Europe
are technically insolvent. When Greece defaults, which it will,
there will be enormous losses sustained by some northern European
banks. When Spain defaults, which it will, these losses will get
far worse. When Italy defaults, which it will, the entire banking
system of Europe will be busted.

The only things
that can save European banking system today are the European Central
Bank, which has the power to create money out of nothing, and the
taxpayers of Germany, whose national leaders are relentless in their
desire to expand the power of the eurozone over all of Europe. These
politicians are willing to write IOUs on behalf of German taxpayers
in order to extend this consolidation.

A DAISY
CHAIN OF DEBT

The problem
is, the Northern European governments do not have any money to serve
as lenders to Greece, Spain, or Italy. They are borrowing money
at rates not seen before in peacetime Europe. These governments
are expected to intervene and lend money to the Greek government.
But every northern European government is now faced with the additional
responsibility of being the lender of next-to-last resort to the
large commercial banks inside its own borders.

Who is going
to lend northern European governments enough money to bail out southern
European governments? Which lenders think this is a good idea today?
At today’s rate of interest, not that many. That is why interest
rates are going to rise. But when long-term interest rates rise,
that will lower the present market value of all of the bonds in
the portfolios of the lenders.

So, on the
one hand, investors have to pony up the money to lend to the governments,
and the governments need the money to recapitalize the banks in
their own borders. This leads to the next problem: in order for
the lenders to lend money to a government, they have to write checks
on their bank accounts. What happens if their banks should go under?
Who will lend money to the governments?

In this daisy
chain of fiat money, credit, and debt, the European Central Bank
is the lender of last resort. It is the lender of last resort because
it has the legal authority to create money out of nothing. It can
buy IOUs issued by governments, and it can lend money to banks,
so that the banks can buy the IOUs of governments.

DAYS
OF RECKONING

The entire
political system that we know as the European Union is dependent
upon a system of fractional reserve banking which has overextended
itself, and now faces a day of reckoning. Actually, it faces two
days of reckoning.

First, there
is a day of reckoning in the PIIGS countries, when depositors withdraw
funds. The second day of reckoning is going to be imposed by the
insolvent governments who have been borrowing hundreds of billions
of euros from the banks.

The arrival
of a bank run threatens the ability of the Greek government to borrow
money from anybody. The Greek government is dependent upon the Greek
banking system to collect taxes. If the Greek banking system goes
belly-up, the Greek government goes belly-up.

In this system,
only the European Central Bank has the authority to bail out the
system. Every other potential source of euros is dependent on the
solvency of the European banking system. But that is exactly what
is at risk today.

This is why
all fractional reserve banking must ultimately rest on the monopoly
granted by government to a central bank. The central bank, above
all, is the guarantor of the solvency of the largest banks. The
central bank is the economic agent of the owners of the largest
commercial banks. These owners are now facing bankruptcy. They hold
shares in multinational banks whose lending officers had no understanding
of basic economics. They wrote checks to the PIIGS.

In this scenario,
the only way to save the system is to risk destroying it. The only
way to save the euro is to risk destroying it. This is because there
are only two ways to save the largest commercial banks. The first
way is by hyperinflation. This will enable the banks to keep their
doors open, but the borrowers will be able to pay off their loans
by selling a handful of hard assets, which will raise enough money
to pay off the loans with worthless euros.

The second
way to save the banks, which is what the European Central Bank is
attempting to do, is to avoid hyperinflation, and to inflate the
money supply only to the degree that the largest banks can be bailed
out by making low-interest loans available to them. They in turn
must lend out the money, if they can find solvent borrowers, and
if those borrowers are willing to borrow.

If the European
Central Bank adopts the second approach, this is going to lead to
a depression. The bank has inflated. The commercial banks have lent
money to insolvent governments. These governments are going to default
if there is a recession, but by refusing to expand the money supply,
the European Central Bank will produce a recession. The boom that
it fostered in the Greenspan years has blown up on European banks,
in the same way that the boom in the United States has blown up
on America’s banks.

There is no
equivalent of the FDIC in the European banking system. There is
no single government that has the assets or the legal authority
to lend to any and all of the other governments. There is no common
fiscal system, which means that all the governments can run massive
deficits. This means that the governments are in constant competition
with each other to borrow enough money to fund their deficits.

So, the system
is stretched to the limits. The few remaining lenders with capital
who have enough money in their banks to write checks to insolvent
governments are now refusing to write the checks. This is why Spain
is paying over 7% to get lenders to fork over their money. Lenders
who do this are going to wind up like the saps who loaned money
to the Greek government prior to 2010. They are going to see the
value of their investments collapse as interest rates go to double
digits in Spain, which they are going to do unless the European
Central Bank intervenes and makes fiat money loans to Spain’s government.

WEEKEND
SUMMITS

There is now
at least one monthly emergency weekend meeting of the political
authorities, accompanied by their bureaucrats from the ministries
of finance. They come together on a Saturday to talk about how they
can save the system. They issue a press release on Sunday. The press
release is always short on specifics. Within a month, the crisis
has escalated again, and there is another weekend summit meeting.

Every time
there is a summit meeting, the investing public that has sufficient
money to invest waits with bated breath to see if there is some
solution offered on Sunday afternoon. There never is a solution
offered, so the stock market drops for the first day or two after
the meeting.

It is clear
by now to everybody that there is no solution forthcoming. There
is no agreement politically, especially between Germany and France,
as to who is going to write the checks to bail out the next PIIGS
government to hit the brick wall.

I can remember
almost 40 years ago listening to a speech by a young hotshot economist
at Yale, who informed us that there would be a new currency system
established in Europe by the year 2000. This was an accurate forecast.
It was established in 1999. The hotshot later moved to Harvard.
He has generally disappeared from public view. But it was clear
from his enthusiastic speech that he was convinced that this new
currency system would create a completely new economic order in
Europe. Boy, was he right!

The new economic
order in Europe is now disintegrating. The establishment politicians,
bureaucrats, and spokesmen are looking in horror as the system which
their predecessors designed to work permanently is disintegrating.
Not to put too fine a point to it, but this is reminiscent of Adolf
Hitler’s promise about the thousand-year Reich. It lasted 13 years.
This year, the euro had its 13th birthday. So far, it has not had
a happy birthday.

NO FIREWALL

The leaders
of European establishment have never had to deal with any crisis
on a scale like this one. They keep talking of the need for firewalls.
Until they have firewalls, nobody is willing to yell “Fire!” Yet
the fire is now raging.

What kind
of firewall can be created that keeps a default by one government
from becoming a default by another government? What firewall is
there for a large multinational bank that has just lost half of
the value of the bonds that it purchased at a rate of 3%, now that
the interest rate is 7%? Every time the interest rate doubles, the
market value of the bonds decreases by 50%, minimum.

There is no
firewall. The financial system of Europe is interrelated by way
of the euro. Everybody uses the same currency in 17 countries. Everybody
is dependent upon the same central bank, and that bank is not exercising
leadership. The head of the bank keeps saying that the governments
have to step up to the plate and take responsibility. Every time
he says this, I am reminded of what Ben Bernanke keeps telling Congress.

The heads
of the two largest central banks in the world keep complaining that
the politicians have got to take responsibility for solving the
crisis. But this is exactly what the politicians do not want to
do. The politicians have always understood that the central bank
would bail them out of their crisis, merely by creating new money
and buying the IOUs of the government. This has always been the
public justification of central banking.

The politicians
seem blind to the real reason for the existence of central banking,
namely, to bail out the largest commercial banks under its jurisdiction.
The European Central Bank faces an enormous problem: it has under
its jurisdiction the largest banks in every country in the eurozone,
other than Great Britain. It has to intervene to save any large
bank that is under its jurisdiction, because if it does not, there
will be bank runs in that nation.

A BANK
RUN

Depositors
can go down to their banks and have money transferred to a bank
outside the country. Usually, this is going to be a German bank.
Legally, the recipient bank can refuse to take a deposit, but what
bank would dare not take deposits? Any bank that would say that
it was not taking deposits from any other bank would be sending
a signal to the media that the other bank is bordering on insolvency.
That is the last thing that any bank in northern Europe wants to
do with respect to any bank in Greece, Spain, or Italy.

The European
Central Bank is sitting on a powder keg. The fuse has already been
lit. That fuse is connected to the Greek banking system. If the
Greek banking system blows up, by which I mean implodes, that will
light another fuse. The other fuse leads to Spain. I could be wrong.
There may be two fuses, one leading to Spain, and the other leading
to Italy.

There is no
firewall. The only firewall would be for banks in northern Europe
to refuse to take new accounts from people who were closing out
there accounts in southern Europe. But if they do not stop the bank
runs from taking place in Greece, the Greek government is going
to default on its debt and pull out of the eurozone. It will have
no choice. If its banks are collapsing, how will it be able to fund
its debt? How will it be able to collect taxes?

You can see
what is at stake here. A small-scale bank run has been going on
for at least a year in Greece, and it is now threatening to escalate
into a full-scale run. Northern European banks could refuse to take
new deposits in euros from existing depositors in Greece. But they
would all have to do this at once. If only one or two major banks
in northern Europe refuse to accept new accounts from Greeks, this
will send a message to all the other Greeks: “You had better get
your money out of your bank, fast, and get it into a northern European
bank that has not yet closed off new deposits.” The bank run escalates.

Because not
all of the banks are under the same banking laws, and because no
regulatory agency can tell them what to do, Europe has a system
in which depositors in PIIGS nations can create massive bank runs
against the banks in their own nations.

There is no
firewall against this. The bank runs have begun in Greece. Banks
outside of the eurozone can refuse to take on new deposits, but
banks inside the eurozone cannot do this without threatening the
survival of the entire banking system. Furthermore, if they do not
create a firewall, the collapsed banks of Greece, Spain, and Italy
will lead to the bankruptcy of their respective governments, and
that in turn will lead to massive losses in northern European banks.

You do not
see a detailed discussion of this in the mainstream press, for very
good reason: the mainstream press is afraid of being blamed for
triggering a bank run out of Greek banks. Everybody in authority
knows a Greek bank run has begun, but this is not front page news.
It is certainly not a story on the evening television news shows.
Maybe “The PBS News Hour” will bring in two or three experts to
discuss it, who will offer rival views, but the network news will
not talk about the Greek bank run until it is in its terminal stage.

So, the people
who run the new European order sit there, helpless, completely dependent
upon decisions made by depositors in Greek banks. At any time, a
wave of fear could spread through Greece, and a majority of depositors
will start lining up to get their money. If they take out their
money in currency, this collapses the local bank, which has to sell
assets to buy the currency from the European Central Bank in order
to hand the currency to the depositor. That kind of bank run is
bad for a single bank, but usually depositors spend the money. When
a depositor spends the money, the business that receives the money
re-deposits the money in its bank. So, a bank run into currency
is not a huge threat to the Greek banking system as a whole.

In contrast,
however, is a bank run in the form of the transfer of digital money
out of the country. All of the Greek banks are facing this threat
today. Once the euros leave the Greek banking system, they are not
redeposited in the Greek banking system.

What we are
seeing is the collapse of the Greek banking system. Unless the European
Central Bank intervenes again, by the end of the year, there is
not going to be a Greek banking system. All of the banks will be
busted.

There is nothing
that the Eurocrats can do about this. The only agency that has the
power to stop this is the European Central Bank, which can do whatever
it wants to do, ultimately, which means lending money to Greek banks
based on any collateral they want to put up, especially IOUs issued
by the Greek government.

CONCLUSION

Angela Merkel
can scream, yell, and hold her breath until she turns blue, but
ultimately she has no power over the European Central Bank. Ultimately,
no politician has any power over it. No politician really wants
power over it. Why not? Because that politician would then be responsible
for coming up with the money that the European Central Bank was
about to come up with, but which was stymied by the politician.

This
is why the European Central Bank is going to inflate, inflate, and
inflate. The head of the bank can make all the comments he wants
about the responsibility of politicians to intervene to keep the
structure going, but he is ultimately the bagman of the system.
He is the guy who has control over the printing press. He is the
only person, along with his colleagues, who is in a position to
keep the system afloat.

There is no
firewall. There is only the ability of the European Central Bank
to create money, and to do so by lending it to commercial banks
or directly to governments. It does not matter what kind of rules
and regulations are in place that were supposed to prohibit this
back in 1999.

In the midst
of a conflagration, nobody in power is going to point a finger at
the European Central Bank when the bank intervenes to bail out a
government that is about to default on its debt. The reason is clear,
or at least is clear to me: no politician wants to be responsible
for coming up with the money to bail out the largest banks in his
country, all of which will be threatened with insolvency because
of the default of Greece and Spain, because that will produce a
domino effect by all of the PIIGS governments.

June
23, 2012

Gary
North [send him mail]
is the author of Mises
on Money. Visit http://www.garynorth.com.
He is also the author of a free 20-volume series, An
Economic Commentary on the Bible.

Copyright ©
2000 Gary North

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