Emerging Local Currencies In The US Disproves The 'Liquidity Trap'

Deflation exponents tell us that deleveraging from overindebtedness will restrict demand for credit and cause a fall in consumption which leads to falling prices.

Further they allege that monetary policies will be ineffective to arrest this phenomenon which leads to a Keynesian "liquidity trap".

We say this is garbage.

Why? Empirical proof from the emergence of local currencies, which reportedly numbers nearly 100, is a manifestation that there hasn't been a fall in demand for goods or services or consumption.

This from Fox News, (all bold highlights mine)

``Today, there are close to 100 types of local currencies operating in the United States.

``While some currencies are true to their name and are backed by federal dollars, others are simply a record of hours worked by contributing “time bank” members. “Whenever you have a shortage of money, people look to invent their own medium of exchange,” said David Boyle, fellow of the New Economics Foundation and Author of "Money Matters."

``The earliest local payment system on record began in the 1930’s, which isn't surprising; historically, local currencies have been most popular during times of economic crisis, and the U.S. then was in the midst of the Great Depression."

``Today, the Community Exchange hours system has 450 members, though similar systems work with just 50 or more members. When one member does something for another, they get credit for the amount of time spent helping. Each member’s time is worth the same, whether they’re giving tax advice or cooking dinner.

``Because there is no set standard for what a local currency should be, many times the grassroots effort to start a program doesn’t gain the momentum it needs. The average success rate for local currency is around 20%, according to a study done by Professor Ed Collom at the University of Southern Maine, which looked at 82 such currencies.

So local currencies operate like an improved version of the barter system but is limited to the locality.

More from MSNBC, (all bold highlights mine)

``In most cases, these communities are simply looking to boost local commerce. The currency has to be spent in town, obviously, because it's worthless anywhere else. But a growing distrust of the U.S. dollar is also at work.

``When the Treasury prints billions to bail out banks and automakers, people look for alternatives. These folks may look nutty now, goes the quip, but wait till the dollar goes the way of the Argentine peso. Then you'll be exchanging a wheelbarrow of cash for a bay buck, local currency boosters say...

``At central Vermont's Onion River Exchange, services recently offered included basics such as haircuts but mostly oddities like puppet shows, trips to the dump and left-handed knitting. Among the service requests were a call for rawhide goat skins and a plea from someone named Pam, who "flushed a hair-catch thingy down the toilet and needs help getting it out."

Here's a list of community local currencies in the US.

So "shortage of money", "a growing distrust of the U.S. dollar" and "boost local commerce" hardly are signs of falling consumption, instead they reflect on the malaise plaguing the banking system.

GMU's Charles Rowley argues on the absurdity of the liquidity trap (hat tip: Cafe Hayek) [bold emphasis mine, italics his]

``The concept of the liquidity trap, as outlined by Keynes, and developed by his early disciples, is one aspect of the theory of liquidity preference. Liquidity preference is a theory of the demand for money. Individuals have a certain transactions and a certain precautionary preference for holding money over bonds, because of money’s property of liquidity. They have a speculative preference for holding money over bonds when their expectations are that interest rates are likely to rise, bringing down upon the holders of bonds significant reductions in the value of their bond portfolios.

``If this speculative fear is sufficiently high, the demand for money becomes infinite. In such circumstances, the monetary authority cannot lower interest rates on bonds by selling money in exchange for bonds on the open market. If this liquidity trap occurs under conditions of recession, the monetary authorities cannot stimulate the demand for investment by lowering bond rates of interest. In such circumstances, increasing government expenditures appears to be an attractive mechanism for returning the economy to full employment equilibrium. As Keynes emphasized, he knew of no such situation ever having occurred in the real world."

So has there been an extraordinary demand for money?

Again from Mr. Rowley,

``There is no evidence whatsoever that the demand for investment at current interest rates (incidentally Treasury notes with more than three years to maturity are nearer to 4 per cent than to zero in nominal terms, Mr. Krugman) is inadequate to move the economy to full employment equilibrium.

``Evidence suggests that small firms are desperate for loans from the banks at current interest rates, but cannot obtain them because the big banks will not lend. The big banks will not lend, not because they are are short of high-powered money (Bad Ben Bernanke has drenched the economy in high-powered money), but because their balance sheets are rock-bottom rotten and they are trying to use Bernanke money to bring their financial ratios back from insanely low levels."

Well, the reported shortages of money that has spurred the emergence of local community currencies seem to validate or corroborate this perspective. Moreover, inflationism could be another factor why people have indeed been looking for alternatives.

Global Foreign Direct Investments Down; US Still Dominates

Here's an update on world Foreign Direct Investments

From the Economist, (bold underscore mine)

``THE flow of foreign direct investment (FDI) fell by 39% in 2009 to just over $1 trillion, from a shade under $1.7 trillion in 2008, according to the UN Conference on Trade and Development. All kinds of investment—equity capital, reinvested earnings and intra-company loans—were affected by the downturn. Rich countries saw FDI inflows plunge by 41%, and foreign investment into developing countries fell by more than a third. Not every country was badly hit. FDI into China, where economic growth remained robust, declined by only 2.6%. Foreigners actually invested more in Germany and Italy last year than in 2008. Despite FDI plunging by 57% last year, America remained the world’s top investment destination."

Additional comments:

-Despite the broadbased downturn, the US remains the largest recipient of FDI. This demolishes the fallacious protectionist notion that emerging markets have been "stealing investments and jobs" from Americans. Not until the US turns into a Peronist Argentina or suffer from outsized or hyperinflation will this happen.

-While the BRICs, especially China, have indeed been seeing bigger share of the FDI pie, they have not been able to supplant FDIs in developed economies...at least, not yet.

-Basically, investments based on free trade is not a zero game that sees one party benefit at the expense of the other. Free trade seen in the light of globalization has generally a net positive effect.

To quote HSBC's Stephen Green in a recent interview with Wall Street Journal, ``globalization is past the point of no return." What's more, globalization "is not an ideology. It's a fact. It's a phenomenon." Despite what certain rich 20-something protesters might have you believe, "It's not as if some thinker has imposed it . . . It's a fact, a phenomenon very deeply rooted in the human spirit."

Instead, it is malinvestments shaped by bubble policies that has severe self-destructive impact to economies by distorting price signals which eventually results to capital consumption.

And worst, it is the mercantilistic proclivities to institute "protectionism" that limits consumer choices which overall imposes an adverse effect to the society. The Smoot-Hawley act which dramatically worsened the Great Depression of 1930s should serve as a grim reminder of the self inflicting harm which results from policy myopia.

Statistics Don't Reveal Extent Of The Evolution To The Information Age

Bespoke Invest gives a good account of the per industry weightings of the US S & P 500.

I think this conveys a very important message.

According to Bespoke Invest, (bold emphasis mine)

``Technology currently has the biggest weighting in the S&P 500 at 19.2%. This is the highest weighting the Tech sector has had since the Internet bubble burst in 2000. After falling all the way down to just 8.9% at the March 2009 lows, the Financial sector's weighting in the S&P 500 now ranks second at 14.4%. Health Care, Consumer Staples, Energy, and Industrials are the other four sectors with a weighting of more than 10%. The Consumer Discretionary sector is close to 10% at 9.8%. From 1998 to 2007, the Consumer Discretionary sector was bigger than the Consumer Staples sector. When the bear market hit in 2007, Consumer Staples overtook Consumer Discretionary, but the spread has tightened to about two percentage points recently. If the bull market continues, we'll likely see Discretionary overtake Staples once again. While the Materials sector gets a lot of attention in the media, especially because it has the gold stocks, it's important to remember that it only makes up 3.5% of the S&P 500. The Utilities sector is even bigger than Materials."

Taking a look at the charts of the S & P Information and Technology we notice that while indeed the sector has significantly outperformed it hasn't reacted in bubble like proportions similar to the late 1990s.

we can also see this in the behavior of the Nasdaq

What I am trying to say is that the contribution of the technology sector to the real economy could perhaps be more accurately reflected on the performance of S&P, however, such contribution may have been underrepresented by conventional statistical metrics.

Even during the aftermath of the dot.com bubble crash, the shift towards advancing high tech industries or high paying tech jobs has also been evident in the job market dynamics.

According to the CRA.org,

``Since 2000 (when trend data become available), there has been a shift away from low-wage jobs to high-wage jobs in the IT sector. The lower-paying IT jobs also have experienced higher unemployment rates and a greater number of job losses. These are the types of jobs that may show signs of being replaced by offshoring. However, the economy is in the midst of an unusual recovery: relatively fewer jobs are being created at the same time that average productivity growth is at the highest level recorded among post-World War II recoveries. This also appears to be playing a role in the lack of job growth in the IT sector."

``An industry-based definition of the IT sector shows a shift from lower-paid manufacturing jobs to higher-paid service jobs. In 1994, 33.4 percent of IT-sector employment were in services. In 2004, this had risen to 54.6 percent. Manufacturing jobs accounted for 70 percent of job losses in the IT sector from 2000 to 2004.

As Erik Brynjolfsson and Adam Saunders of the MIT Sloan writes, (bold highlights mine)

``The irony of the information age is that we know less about the sources of value in the economy than we did 25 years ago. GDP is a more accurate metric of value in industrial-age industries like steel or automobiles than in information industries, and can miss most of the value in information goods. However, there is one measure that economists have thought about for decades that may help us determine the value of these innovations: consumer surplus. Consumer surplus is the aggregate net benefit that consumers receive from using goods or services after subtracting the price they paid. While it can be difficult to measure directly, economists can infer consumer surplus using price experiments from purchase data, lab experiments or surveys. Consumer surplus can be enormous even if — in fact, especially if — the price is low or zero.

``Let’s go back to the recording industry. Suppose that for most people, the vast majority of the value of a CD comes from their three favorite songs on it. Those consumers will do much better paying $3 for those three songs on iTunes, rather than paying the $18.99 retail price for the CD. While most of the record company revenues disappear from GDP, consumer surplus increases enormously — but that amount is unmeasured. This is not a bug in the free market system. In fact, it is its essence. As Adam Smith noted more than 200 years ago, the invisible hand of competition drives producers to deliver ever more value to consumers at an ever lower cost. If the cost of producing a good is zero, then over time, the competition should drive the price to zero as well. The invisible hand has been particularly ruthless in information markets. As a result, consumer surplus has soared even if the contribution of information goods to GDP hasn’t."

In short, there is growing evidence that statistical GDP does understate the role of technology in the real economy.

A final note from Murray N. Rothbard,

``Technologically, history is indeed a record of progress; but morally, it is an up-and-down and eternal struggle between morality and immorality, between liberty and coercion. While no specific technical tool can in any way determine moral principles, the truth is the other way round: in order for even technology to advance, man needs at least a modicum of freedom to experiment, to seek the truth, to discover and develop the creative ideas of the individual. And remember, every new idea must originate in some one individual. Freedom is needed for technological advance; and when freedom is lost, technology itself decays and society sinks back, as in the Dark Ages, into virtual barbarism."

Freedom is progress.

Getting Ahead Of The Curve

``Actually, the Fed is a public-private partnership, a coalition of large banks who are the owners working with the blessing of the government, which appoints its managers. In some way, it is the worst of both the corporate and the government worlds, with each side providing a contribution to an institution that has been horribly detrimental to American prosperity. In any case, William Greider is exactly correct that the advent of the Fed represented "the beginning of the end of laissez-faire." It turned the entire money system over to public management on behalf of political causes.” Dr. Ron Paul End the Fed

Author, economic professor and prolific econlib blogger Arnold Kling writes, `` The Fed has changed from a central bank to a piggy bank. Any economist who tries to interpret Fed policy from the standpoint of economic theory is playing a fool's game.”

Exactly. That’s what been we’ve been saying all along.

In a world where markets (especially in the US) have essentially been artificially patched up by different government measures and policies, such as lender, liquidity provider, buyer, investor, market maker, guarantor, spender, and other assorted roles of last resorts, repeated attempts to interpret these actions into conventional fundamentals (corporate fundamentals or economic theory) seems like a mug’s game-market actions haven’t been playing out most of its traditional roles.

Figure 1: Minyanville: US Earnings Volatility!

As you can see earnings volatility today in the US have spiked to the levels of 1930s due to increased “leverage” and “inflation”.

Kick The Can Down The Road

Yet I’ve been asked how should we get ahead of the curve? My reply would be simple: we should think out of the box.

Many if not most of the mainstream’s favorite experts- the financial or economic Op-ed writers, the academe bloggers turned opinion maker, celebrity gurus and etc.-have essentially misread the markets in 2009, yet are still patronized by many and in fact glorified by media.

Gullible followers fail to realize that for these talking heads, the cost of being wrong had been inconsequential.

Inaccurate analysis or misplaced forecasts don’t cost them their jobs or that they don’t even lose a dime, that’s because many of these so-called experts are even hardly invested in the markets. For most, they practice what popularly is known as being ensconced in the proverbial “ivory tower” thinking or from wikipedia.org “pursuits that are disconnected from the practical concerns of everyday life.” They mistakenly believe that models can substitute for human actions.

Yet these experts remain trustworthy sources of information because they provide mostly entertainment value- by confirming or echoing on the beliefs of the audiences. But what makes them even more believable is that their arguments has been embellished by scientism, such that, when a hunch is backstopped by math models, they seem intellectually credible, even if they have been repeatedly falsified. So it is not being accurate that matters but feeding on popular but mostly “delusional” creeds.

Worst, the avid spectators can’t seem to tell between propaganda masquerading as analysis from an objective and independent investigation.

For instance, many have been made to believe by the authorities and the mainstream that today’s collective policies have been “successful” in mending the markets.

It’s all a matter of perspective.

For us, it is known as a children’s game called “kick the can down the road”; for the short term yes, markets appear to be cosmetically pacified, but no, imbalances have merely transferred and deferred which eventually would unravel anew in a far more worst degree.

In short, merely delaying the day of reckoning does not solve the crisis. Obviously the laws of nature will ultimately compel adjustments overtime (see figure 2).

Figure 2: MoneyandMarkets.com: Bust Getting Bigger

In the same way as it recently had.

US government policies aimed at cushioning the losses in the dot.com bust (left window where loses had been estimated at $6.5 trillion) have led to a bigger housing bubble and the attendant larger “doubling” of losses from the recent bust (right window- $15.5 trillion).

And it is of no wonder why many who concur with this present day government actions seem paradoxically afraid of the future. They are allured to short term unsustainable fixes in the same way as drug addicts are temporarily satisfied by the infusion of toxic substances.

Such incoherence exposes the fatuousness of their beliefs- turning stones into bread by the magic of inflation. Yet no matter the realization of such chronically flawed principle, they embrace these as if it is an act of faith.

When Everyone Thinks Alike, Then Nobody Is Thinking

Bemedalled World War II US General George S. Patton once remarked, ``If everyone is thinking alike, then somebody isn't thinking.”

IF in the present environment, markets are shaped by political action, how does one get ahead of the mainstream?

For us the answer is by comprehending on the thought process that governs the mainstream.

Think of it, there are 3 research divisions of the US Federal Reserve which has a vast army of 450 economists from where about half of them of are Ph.D. economists!

So common sense tells us if we think in the line of the mainstream, 450 economists with their panoply of computer aided econometric models would have easily beaten us to the punch. That’s assuming if they’re right.

Yet, these do not include the scores of economists that are employed in the Fed’s 12 regional banks.

In addition, the tentacles of the Fed network are way far reaching more than what the public expects.

In essence, the US government, particularly the US Federal Reserve, influences or shapes its own public image (and of course ideas).

How? Through several factors:

1. Self-publication or by influencing the materials that are published in mainstream Journals

Cato’s Steve Hanke writes, ``One of the reasons the Federal Reserve gets so much good press is that it’s publishing most of it itself” (italics mine)

Mr. Hanke quotes Professor Gordon Tullock: ``Milton Friedman has pointed out that one of the basic reasons for the good press the Federal Reserve Board has had for many years has been that the Federal Reserve Board is the source of 98% of all writing on the Federal Reserve Board.” (bold emphasis mine)

Mr. Hanke also cites the work of Professor Larry White, ``In 2002, 74% of the articles on monetary policy published by U.S. economists in U.S.-edited journals appeared in journals published by the Fed, or were authored (or co-authored) by Fed staff economists.”

So the predominance of Fed friendly papers makes it appear that their methodology constitutes as the predominant and most acceptable thought.

2. Outsource jobs and offer privileges

Aside from having a say on the articles published on mainstream economic journals, Ryan Grim of the Huffington Post says that the US Federal Reserve has outsourced many of its work to the academia and has equally bestowed intangible benefits and privileges to them.

From Mr. Grim, ``The Fed also doles out millions of dollars in contracts to economists for consulting assignments, papers, presentations, workshops, and that plum gig known as a "visiting scholarship." A Fed spokeswoman says that exact figures for the number of economists contracted with weren't available. But, she says, the Federal Reserve spent $389.2 million in 2008 on "monetary and economic policy," money spent on analysis, research, data gathering, and studies on market structure; $433 million is budgeted for 2009… Being on the Fed payroll isn't just about the money, either. A relationship with the Fed carries prestige; invitations to Fed conferences and offers of visiting scholarships with the bank signal a rising star or an economist who has arrived.” (all bold emphasis mine)

So the academe is not only paid by the Federal Reserve but latently coaxed into writing articles or papers in the Fed’s light.

Mr. Grim also cites a research by Robert Auerbach, a former investigator with the House banking committee who apparently scrutinized on the operating network employed by the Fed. Mr. Grim adds, ``Auerbach found that in 1992, roughly 968 members of the AEA designated "domestic monetary and financial theory and institutions" as their primary field, and 717 designated it as their secondary field. Combining his numbers with the current ones from the AEA and NABE, it's fair to conclude that there are something like 1,000 to 1,500 monetary economists working across the country. Add up the 220 economist jobs at the Board of Governors along with regional bank hires and contracted economists, and the Fed employs or contracts with easily 500 economists at any given time. Add in those who have previously worked for the Fed -- or who hope to one day soon -- and you've accounted for a very significant majority of the field.” (all bold emphasis mine)

3. Influencing public policies through the mainstream networks

One of the advantages of the Fed’s employment of a large external network is to be able to put pressure on public policies that favors its interests.

Huffington Post’s Mr. Grim addresses such conflict of interest issues by citing anew Robert Auerbach work, ``Auerbach concludes that the "problems associated with the Fed's employing or contracting with large numbers of economists" arise "when these economists testify as witnesses at legislative hearings or as experts at judicial proceedings, and when they publish their research and views on Fed policies, including in Fed publications." (all bold emphasis mine)

As in the case of the recent reappointment of Ben Bernanke as the Chairman for the US Federal Reserve, when politicians warned the public that a failure to extend his tenure would result to doomsday, you now know how the politics behind the Federal Reserve operates.

Profiting From Folly

But of course the goals of the investors and policymakers are different. The goals of the investors is to profit from making the right decisions in the marketplace while the bureaucracy and their externally based affiliates are no less than vying to eternally meet the ever elusive “appropriate” policies in response to the changes in the market.

As Professor Antony Mueller rightly observes, ``This challenge is quite different from textbook models, with their neat separation between a definite object, a tested theory, and a neutral observer. It is one thing to do academic economic research; it is quite a different task to decide and to act on the basis of incomplete, contradictory, and largely false data.

``It is hardly a wonder that Bernanke and his team are in a constant panic. The economic data they are so eager to get in order to make "rational" decisions are inaccurate, inconclusive, and always false: at the very moment when the data are gathered, economic constellations have already changed, often quite drastically.”

Like many terminally ill people who desperately would seek cures by resorting to quack medicines, the same applies to bureaucracy. Professor Arnold Kling, a former Federal Reserve and Fannie Mae officer, notes that quack medicine appear to have an inelastic demand in spite of “demonstrable failures”, that’s because ``People who are really sick tend to cling to unreasonable hopes” notes Professor Kling.

Prof. Kling germanely observes that, ``decision-makers with a lot of power are desperately needy for scientific solutions in the same way that individuals with serious afflictions are desperately needy for remedies. As a result, decision-makers fall for models the way sick individuals fall for quack medicine.” (bold emphasis mine)

In other words, the best way to think out of the box is to bet against unreasonable hope of the mainstream, which has been mostly borne from the market interventionist policies instituted by a presumptuous government desperate for immediate remedies.

And this means to quote Warren Buffett, ``Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

As an addendum, I’d like to add that this clearly looks like a case where taxpayer money is being ceaselessly drained in a seeming abyss of “sunk costs”- where the government spends more to sustain or promote its wellbeing than to serve the interest of the public.

Lastly, as for mainstream-ism applied to the local stockmarket; many market participants are enticed with rumor based “action” than from practicing prudence or from positioning on a risk-reward tradeoff. Hence most of the vulnerable participants subscribe to “action” based stimulating sources of information.

Well, since markets are mainly about profits and losses, people usually get what they deserve.

Why The Greece Episode Means More Inflationism

``The European capital market institutions would not be able (or even willing) to step up to the plate and negotiate a restructuring. The ECB is not allowed to. And the EC is not up to it. There is an alternative -- the IMF has specific experience in this regard. But, allowing the IMF in would be an admission that the Euro area has not quite made it as currency union. The IMF, given its historical origin with exchange rate mechanisms, would convey a message that the big Euro players would not like to see. It would tar the reputation of the Euro even if there are no contagion effects on other PIIGS. Moreover, allowing Greece out of the Euro (or kicking) it out would be even worse. That is why, I think, the Germans will pay up. They will pay to maintain the reputation of the Euro. Americans underestimate the commitment to the Euro.” –Paul Wachtel Thoughts on Greece's debt problems

Prior to last week’s intermission, we noted that like the Dubai debt crisis, the Greek dilemma would seem like a political issue more than an economic one and therefore, as we suggested, would be resolved politically.

And by politically, we meant that arguments for sound policies or by imposing harsh or rigorous discipline against a wayward member of the EU would be subordinate to the practice of inflationism.

And as per the mainstream, the most recent volatility in the global markets had been mostly attributed to either the prospects of a contagion from the risks of a Greece default or from the attempts of China to wring out inflation out of its system.

Nevertheless, we have not been convinced by verity of the alleged cause.

While key benchmarks across asset markets have indeed broadly deteriorated then, which somewhat did raise some worries on my part, the correlation and the supposed causation did not seem to square [see Global Market Rout: One Market, Two Tales].

If indeed there had been a generalized anxiety over a contagion of rising default risks from sovereign debts, then sovereign CDS AND sovereign YIELDS, aside from corporate and bank lending rates would have spiked altogether!

In addition, considering the scenario of a run from sovereign securities, the contagion should have been largely a regional dynamic and paper currencies would not have been seen as the safe shelter, since the major currencies of the world have all similarly afflicted by the same disease!

What happened instead was a palpable shift to the currency (US dollar) of the lesser affected nation (the US) which somewhat resembled a “flight to safety” paradigm of 2008. With the trauma from the recent crisis along with automatic stimulus response [as discussed in What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?] some have mistakenly labeled the recent events as the unwinding US dollar carry trade.

Yet, as CDS and yields went on the opposite course, Baltic stock markets soared and gold plummeted validating our observation that the precious metal, which has served as man’s money throughout the ages, has been exhibiting a tight correlation with the Euro or a proxy thereof, instead of deflation or inflation signs [see When Politics Ruled The Market: A Week Of Market Jitters]. This tight correlation appears to have been broken last week! (see figure 3)

Figure 3: stockcharts.com: Gold-Euro Break, US 10 Year Yield, JP Morgan Emerging Debt Fund

The contour of the Euro and Gold trendlines has been the same over the 6 months up until last week!

Since gold has served as lead indicator of asset markets since the depths of 2008, including the recent selloffs, any resumption of an upward trend by gold is likely to be signs that asset markets will be headed higher soon.

Ergo, Gold above 1,120 should likely serve as my trigger for a buy on equity markets.

Moreover the major US sovereign benchmark, the 10 year Treasury yield (TNX), in spite of the recent stock market setback has remained stubbornly high. Also the JP Emerging Market Debt Fund (JEMDX), in spite of the recent China and Greek jitters, remains buoyant.

In other words, those expecting a repeat of 2008 or of a deflation scenario appear to be in a wrongheaded direction.

What seems to be in place is that the markets seem to be looking for a reason to retrench or has been reacting to the discordant tones from the mixed messages transmitted by the political and bureaucratic authorities. In short, if markets had been recently buoyant out of a flood of global liquidity then qualms over a liquidity rollback appear to be the major concern.

Inherent Defects In The Euro

Any major liquidity rollback for developed economies would most likely be deferred, with the Greek and the PIIGS issues signifying as one of the principal reasons.

Remember since the PIIGS is a political issue then any attempt to resolve the Greek crisis will be political.

Professor Paul Wachtel in a New York University forum captures it best, ``It is not Greece, it is the Euro. A troubled small country can be shrugged off but a currency area is either whole or not. The Germans will pay up to keep the Euro area in tact.”

True. A united Europe has been a longstanding project since the close of World War II. Monetary integration has been in the works through the European Monetary System since March of 1979.

So the Euro isn’t just a symbolical currency that can easily be jettisoned, instead it is a sense of pride for the major European economies that make up the core of the European Union. Hence it won’t be easy to dismantle a pet project for Europe’s social democrats.

However since the Euro is another monetary experiment it comes with inherent flaws in it.

For instance, the inclusion of Greece to the European Union has effectively bestowed subsidy privileges to her by the European Central Bank (ECB) even prior to this crisis via an intraregion carry trade.

Where the interest rate spread of Greek sovereign instruments had been wide relative to core Euro members, European banks bought Greek bonds and used them as collateral to extract additional loans from the ECB. Spendthrift socialist Greece, in turn, took advantage of this easy access to money to fund lavish public expenditures.

As Philip Bagus explains, ``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

The latest US centered bubble exacerbated the carry trade and the intraregion subsidies of the PIIGS which eventually rendered European banks as highly sensitive to a PIIGS default (see figure 4).

Figure 4: Bloomberg: Shot Gun Wedding

According to Bloomberg’s Chart of the Day, ``Banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the so-called PIGS.”

So not unlike the US, the European Union will most likely persist in subsidizing subprime PIIGS and the European banking system at the expense of the rest of its society.

And also not different from the US, the risks of unsustainable welfare states will likely be a part of the currency and asset equation.

NYU’s Mario Rizzo bluntly writes, ``People like to deny reality when it is unpleasant. This is not just a problem of bad leadership. It is a problem that goes to the heart of the fantasy world the typical voter lives in. Buy reality bites. Let’s see how it does so in the next few years.” (bold highlight mine)

Moreover, the underlying systemic subsidies incent European member state beneficiaries to expand spending. Obviously such feedback loop mechanism of incremental subsidies and deficit spending will ultimately be untenable.

Again from Philip Bagus, ``For the member states in the eurozone, the costs of reckless fiscal behavior can also, to some extent, be externalized. Any government whose bonds are accepted as collateral by the ECB can use this printing press to finance its expenditures. The costs of this strategy are partly externalized to other countries when the newly created money bids up prices throughout the monetary union.

``Each government has an incentive to accumulate higher deficits than the rest of the eurozone, because its costs can be externalized. Consequently, in the Eurosystem there is an inbuilt tendency toward continual losses in purchasing power. This overexploitation may finally result in the collapse of the euro.” (bold emphasis mine)

So perhaps it wouldn’t be systemic rigidities that could undo the Euro, as preeminent monetarist Milton Friedman warned about [or the tradeoff between ``greater discipline and lower transaction costs outweigh the loss from dispensing with an effective adjustment mechanism”] but the untenable cross subsidies and systemic inflationism inherent within the system.

Easy Monetary Policies To Continue

And the political response has been as what we had expected.

An article from Bloomberg says Europe will use former US Treasury Secretary Hank Paulson’s “Bazooka” approach to deal with Greece, ``European leaders closed ranks to defend Greece from the punishment of investors in a pledge of support that may soon be tested. German Chancellor Angela Merkel and her counterparts yesterday pledged “determined and coordinated action” to support Greece’s efforts to regain control of its finances. They stopped short of providing taxpayers’ money or diluting their own demands for the country to cut the European Union’s biggest budget deficit.”

Like short selling, the blame has always been pinned on the markets. However, as discussed above, the woes of the PIIGS exhibits a structurally flawed monetary system.

The fact that Greece fudged its numbers to get into the Euro membership serves as damning evidence of EU’s incompetence. Investors don’t just punish nations without any basis. Investors get burned for making the wrong decisions.

On the other hand, bilking taxpayers, misrepresentation and mismanagement are enough justifications for punishment, not only from investors but from the resident political constituency. True, international sanctions won’t likely work as policymakers are too tied up rescuing each other.

Of course, tightening of monetary policies today won’t help the cause of the EU or the US from executing bailouts and rescues of their political patrons. Hence we can expect deferred “exit strategies” and even extended quantitative easing programs.

Oh, did I just mention the US as possibly help fund a Greece bailout? Yes, apparently. This according to Financial Times, `` European governments are expected to turn increasingly to US investors to help them meet their funding requirements as record levels of bond issuance make it harder to attract buyers.” (bold highlight mine)

So whether it be the IMF (where the US has the largest exposure representing 17% of voting rights) or direct participation from US investors we can expect somewhat the US to be a tacit part of the rescue team. Sssssssshhhhh.

Perhaps, some Asian nations as China may take part in it too.

What do you expect, it’s a paper money system! Government central banks can simply print money and channel them into sectors or economies in dire straits, in the hope that the money printing has neutral effects.

All the imbalances we’ve just spelled out here is a medium to long term perspective, which means they aren’t likely to unravel anytime soon.

But it is one of the risks that should be reckoned with overtime.

For the meantime, the triumphalism of the Philosopher’s Stone or the alchemy of turning lead into gold will likely still work its interim or immediate wonder. That’s why it has been the preferred du jour priority option by policymakers.

And importantly, that’s why it gives confidence to the global political authorities to do all their redistributive programs.

Meanwhile, expansionary policies from the EU and the US are likely to continue. And this should help support the asset markets.