Monetary Mess, the Dollar, Gold—and You, Part II

(For Part I of this series, click here)

Just like national governments and international businesses employ derivatives to protect themselves against currencies that are losing value, states and local governments have turned to derivatives for the same reason. But protective efforts that served well against inflation proved costly when the bubble burst. Anthony Luchetti writes:

Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities....

The Los Angeles city council approved a measure...to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year....

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June [2009]. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap...

As of June 10, 2010 the Illinois Teachers Retirement System's list of derivatives it owns ran seven pages. Its pension fund was the fourth-riskiest investment portfolio for a pension fund in the U.S., with 81.5 percent of its investments considered risky. It lost $88 million on derivatives in 2009. For 2010, it lost an estimated $515 million on them as of March 31. Its $33.72 billion pension fund is now underfunded by $44.5 billion, or 60.1 percent, according to the Commission on Government Forecasting and Accountability.

The Service Employees International Union says locals in Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon have all lost money on swaps, ranging from a few million to over $100 million dollars a year.

But that is by no means the end of the string of losses from government policies that have been destroying the value of money. Remember how the collapse of residential mortgages in the U.S. triggered massive losses for governments, banks and other financial institutions around the world, particularly in Europe? They held huge investments in securities tied to U.S. home mortgages and suffered losses of hundreds of billions of dollars from the ensuing defaults. Well, foreign banks now face a similar threat from a Greek default because they own large quantities of Greek bonds.

Because countries in the euro zone share a common currency, there was no risk of currency fluctuations among countries in the zone. As a result, banks, insurance companies and pension funds in every euro-zone country became the biggest investors in bonds issued by other euro-zone countries. In the case of Greece, 90 percent of its public debt is held by foreigners, who could be expropriated by a default. French and German banks have by far the largest exposure to Greek debt. (Is it a coincidence that those are the two countries which led the effort to bail out Greece?)

The recession has made things worse. There are now other euro-zone countries besides Greece with debt burdens well above the euro-zone limit of 60 percent of GDP. Scornfully known as PIGS (or PIIGS, if Italy is included), these countries have the following debt-to-GDP ratios, according to the International Monetary Fund: Portugal 85.9%; Ireland, 78.8%; Greece, 124%; Spain, 66.9%; and Italy 118.6%. In May 2010, Fitch Ratings lowered Spain's AAA credit rating to AA, putting it in line with a similar rate cut by Standard & Poor's the previous month. Fitch said that government's debt is likely to reach 78% of GDP by 2013, compared to less than 40% before the 2007 financial crisis and the subsequent recession. Collectively, internationally active banks in the 16 countries in the euro zone hold $1.58 trillion, or 62% of the debt of the PIGS, according to the Bank for International Settlements. That leaves 38% spread around the rest of world, further exporting the problems.

Greece accounts for only 2 percent of euro-zone GDP, and Greece, Ireland and Portugal together account for only about 6 percent. But Spain accounts for 11 percent. It has a trillion euro economy, the fourth-largest of the 16 nations in the euro zone, and the ninth largest in the world. It also has 20 percent unemployment and a million vacant homes from that nation's housing bubble. According to Morgan Stanley, 32% of Spain's $748 billion debt is held by German banks and 25% by French banks. And 51% of Portugal's $165 billion debt is owned by Spanish banks. And U.S. banks hold more than $1 trillion in European debt. So you can see how intertwined the banks are and how easy it would be for problems to spread worldwide, just like the housing bubble did.

The global interconnectedness of banks is also shown by an example from Ireland. Patrick Honohan, Governor of the Central Bank of Ireland, who also sits on the ECB governing council, said the real estate bubble fueled by Irish banks was financed to a large extent from abroad. He said between 2003 and 2008, “net indebtedness of the banks to the rest of the world jumped from 10% of GDP to over 60%.” He noted that many big loans to property developers are unlikely to be repaid. Peter Johnson, M.I.T. professor and former chief economist of the International Monetary Fund, and Peter Boone, of the London School of Economics, earlier this year wrote:

Ireland's banks are today probably insolvent. Who can afford to repay their mortgages when wages are falling and unemployment is rising? Irish house prices continue to speed downward. This [Ireland's austerity program] is not an example of a 'careful' solution—it is a nation in a financial death spiral....

If one country must make a substantial and painful fiscal adjustment, eventually the rest will follow. The implication for bondholders is obvious: Edge toward the door. Bond yields will stay high or creep up, until the next crisis and contagion. The problems could easily jump beyond Europe.

The United Kingdom is not a member of the euro zone, but it, too, has debt problems. In recent months the ratings agencies have warned it could lose its AAA rating unless it comes up with a tough, credible program to cut its deficit. The deficit was 10.4% of GDP for the last financial year but is now said to be approaching 12%. The public debt is now 70% of GDP and rising. A disturbing indication of concern about U.K. finances is the rapid rise in investor purchases of credit default swaps to protect against a U.K. default. The size of this protection roughly doubled in the first four months of 2010, a far sharper run-up than Greek CDS last fall.

In a speech on April 15, 2010 Jurgen Stark of the ECB told a Washington audience that the euro zone wasn't the only region facing major fiscal challenges. He said, “Outside the euro area, bringing the public debt ratio back to safer regions appears even harder for the United Kingdom, the United States and Japan.”

It is governments that have created the problems of massive public debt in countries all over the world. They alone are responsible for government spending and monetary policies. They are quick to blame the banks, Wall Street, hedge funds, “speculators,” the real estate industry, Chinese imports, deregulation, credit default swaps or any other handy scapegoat for the credit bubble they themselves produced by their laws and regulations. And now they demand—as a cure (!)—more of the laws and regulations that caused the problem in the first place, and which will allow them to further disguise what's been going on and to extend it.

“Under a properly functioning gold standard, the U.S. would not have been able to borrow itself to the threshold of the poor house,” says James Grant, one of the most astute monetary analysts and long-time editor of Grant's Interest Rate Observer. When accounts had to be settled by a nation parting with its gold, the system was self-correcting. A credit inflation that permitted the U.S. to accumulate a $2.45 trillion debt with China would not have occurred. The U.S. abandoned the dollar's final link to gold in 1971, and it has consumed more than it has produced (measured by international trade balance) every year since 1976. According to the government's own inflation calculator on its Bureau of Labor Statistics website, the U.S. dollar has lost more than 95 percent of its purchasing power since the Federal Reserve Act of 1913, and more than 81 percent since 1971. The BLS bases its inflation calculator on the Consumer Price Index. Other methods of calculation show even greater inflation, as in this example:

The chart is by Dr. Arthur Laffer from an article in the Wall Street Journal June 10, 2009. I recommend you read the full article. It explains, “The percentage increase in the monetary base [since September 2008] is the largest increase in the past 50 years by a factor of 10....The currency-in-circulation component of the monetary base...has risen by a little less than 10% while bank reserves have risen almost 20-fold.” The full effect of this is yet to be felt.

For Part III of this series, click on this link