Merry Christmas -- and Part III
It's finally here -- the Christmas-New Year Holiday Season. And in a sign that the world retains some sense of sanity and decency, we're happy to report that, indeed, much of the activity that surrounds us is winding down, right on schedule. Our minds lose their focus on work as our hearts (and stomachs!) long for those wonderful celebrations with family and friends.
As long as Christmas comes once a year to conquer the worries, anxieties and sheer exhaustion that threatens to overcome us in these troubled times, we'll be ready for anything the world might have in store for us in 2012.
In the spirit of the holidays, we'll keep this letter short and sweet before finishing up 2011 with some thoughts about Christmas from the author of that most beloved of Christmas stories.
On to the final part of our effort that began two months ago:
A Simple, Direct Explanation of the
European Debt Crisis and Why It Matters to Us
In Part 1, we focused on the role of governments and politicians in setting up the crisis. In Part 2 we explained how banks played the role of enabler as they lent money to governments in spite of the growing evidence that their loans could never be repaid, noting:
So now people are basically calling the banks on the carpet and saying they should value the bonds they hold on their balance sheets at what they're really worth, not what they paid for them when they were new (i.e., when the bonds were issued by the governments).
As for the governments, even though it's been obvious to many of us for years, apparently it's gotten so obvious now, people just won't accept the fiction that the governments can ever pay up on their obligations.
But wait. Just when you thought the powers-that-be might finally be forced to face up to the enormity of the problem, maybe even fess up to their role in causing the whole thing in the first place, we hear instead that they've found a new way to stop the growing crisis. It will be a new, more permanent solution -- something called "ring-circling."
What this "ring-circling" might mean is yet to be clearly defined. But the image is clear: a circle will be "drawn" around each threatened country. (I tried picturing the bankers and government officials joining hands singing "Ring Around the Rosey" but that didn't help.) We're assured that the river of government debt will not overspill its banks. Whatever happens in each country will somehow remain there.
Considering what we're facing here, you can understand the need for a meaningful solution. As the crisis progressed through the smaller economies of Iceland, Ireland, and Greece, the threat appeared contained. But now the big boys -- Italy, Spain, France and, yes, even mighty Germany -- may face debt defaults. Given all that, "ring-circling" certainly does have a nice, well, ring to it, doesn't it?
On the other hand, this ring-circling stuff frankly reminds me of the claims made about how Fukushima and New Orleans would be protected by levees -- before a tsunami and a hurricane set the record straight.
What Fukushima and New Orleans Can Teach Us
about the European Debt Crisis
The catastrophic meltdown of the nuclear reactor in Fukushima, Japan was caused by a tsunami resulting from an earthquake. The wave overwhelmed the levees built to protect the nuclear reactor. The levees didn't crumble. The wave was simply higher than the levees. That "ring-circle" wasn't high enough.
When Hurricane Katrina hit New Orleans, the water didn't overwhelm the levees. The levees failed. Watch this video of the breached levees in New Orleans. (It's only 5 minutes long.) You'll see the first rescuers who were interviewed as they give us the low-down on what really happened. Even if the levees were indeed constructed high enough (and we'll never know if they were) that "ring-circle" simply collapsed.
In both cities, government officials had reassured their citizens for decades that they would be protected in the event of a catastrophe - in the one case an earthquake, in the other a hurricane.
(In fact, you can hear at the end of the Katrina video how government officials kept what really happened from the public for months -- just as Japanese officials kept the truth about the seriousness of the Fukushima meltdown from the public as long as they could.)
Will this "ring-circling" of the European debt crisis work? Should we believe the reassurances of bankers and government officials? The evidence already says otherwise.
Has a Derivative "Time Bomb"
Already Started Ticking?
To understand why we should question the efficacy of these "ring-circling" efforts, we return to something we pointed out last month:
...U.S. banks have committed to making billions of dollars available to European banks in the event of a European government default.
Not only have U.S. banks sold this insurance (called "credit default swaps") to European banks, but the U.S. Federal Reserve has offered its assistance to European banks as well. For example, when it became known that European banks were running low on U.S. dollars, the Fed provided something called "currency swaps" that basically allow the European banks to give Euros to the Fed in exchange for the dollars they need.
These credit default swaps and currency swaps are part of a massive complex of financial instruments known as "derivatives." While we don't have time to discuss this subject in any substantive way, we can simply defer to Warren Buffet's words written in his company's annual report almost ten years ago (our emphasis):
I view derivatives as time bombs, both for the parties that deal in them and the economic system… The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
(You can find his comments on derivatives edited from the Berkshire Hathaway 2002 Annual Report by clicking here.)
When Buffet penned these words, what's called the "notional value" of derivatives was somewhere south of $300 trillion. Now their notional value is somewhere north of $700 trillion (yes, with a "T").
And we already have evidence that the European debt crisis already almost set off a potentially cascading chain of derivative explosions when European banks took a "hair cut" on the Greek bonds they were holding. The "hair cut" means that banks would officially recognize that the Greek bonds held by European banks weren't really worth 100 cents on the dollar (no surprise to anyone). The banks agreed to mark the bonds down by 50%.
But by doing so, they triggered payment on those credit default swaps, which were a kind of insurance sold to them by other banks who promised to pay up if the bonds lost value. But the banks who promised to pay up never did.
What happened was something like if you had a house fire that ruined half your house and your insurance company told you -- after the fact -- that your insurance only covers you if the whole house burns to the ground. Of course you wouldn't put up with such nonsense. But the banks that held the credit default swaps did.
Why? The simple explanation: fear.
Remember that credit default swaps played a big role in the collapse of the largest insurance company in the world, AIG, in 2008. The government had to bail them out.
We found out that apparently no one had a clear understanding of the risk faced by AIG then. We can safely imagine now that no one really has a clear understanding of just what might happen if credit default swap contracts were honored now.
Think of it this way. The levees protecting Fukushima and New Orleans were a lot easier to understand than the potential interaction of $700 trillion of derivatives. And we know what happened to those levees. We must assume the bankers and government officials put their heads together and agreed that the real consequences of paying off on those credit default swap derivatives were either beyond their understanding or, perhaps, simply much worse than they had imagined.
Rather than calling for a government bailout, this time the solution was to ignore the contracts. While most of us would agree that yet another bail-out would be unacceptable, I'm not so sure a clear breach of contract law is any better. Accepting a breach of contract law doesn't bode well for the future of a civilization built on rule of law, wouldn't you agree?
Meanwhile, that massive pile of $700+ trillion of derivatives contracts sits intact -- for the time being.
And just in time for the holidays, the European Central Bank decided to lend roughly $700 billion to European banks who need cash -- like NOW. It looks like this will keep things quiet at least until 2012 -- which is, of course less than two weeks away. Will they have a real solution after the holidays - a more or less permanent solution? We'll have to wait and see. Just don't hold your breath.
How the Debt Crisis Must End
We've finally reached the point where we can talk about how this debt crisis will end -- actually how it must end.
Let's first recognize that government debts, deficits and all the benefits they've promised to their citizens both now (which cause the deficits), and in the future (the so-called "unfunded" social entitlements) are real. The $700+ trillion of derivatives are real. They won't just disappear on their own.
Ending the crisis -- not just kicking the can down the road -- will require, at some point, the elimination of all debt, deficits, unfunded social entitlements, and the $700 trillion (or at least a significant portion) of derivatives. How will these be eliminated? There are two possible ways.
First, governments could default on their obligations. This would cause severe deflation, leading to a collapse of not just the big banks, but the entire world's banking system, which, in turn, will lead to untold economic pain, including riots and violent political change.
(Sorry. I realize it's almost Christmas -- a joyous time of year -- but I didn't create the problem and I learned a long time ago that burying your head in the sand never resolves anything.)
But for a default to occur, politicians, who are elected or appointed for relatively short terms, and who want to be re-elected, would have to summon up the will and make decisions which they simply won't make. Their desire to be re-elected (and re-appointed) means they will make any decisions that would prevent default and deflation.
They will try to prevent default and deflation by using the one trick in their bag that only they can use -- print money. Their immediate hope will be that this will prevent a melt down on their watch -- a form of kicking the can down the road, something they've already tried and tried and tried again.
What about eventually having to wipe the slate clean? The odds point to governments printing so much new money that ultimately it will serve to dramatically reduce the value of their currencies (we could say "destroy the value," but, after all, it's Christmas). This includes all of the currencies around the world that can be printed at will by governments, which, in fact, includes all the currencies around the world.
When the currencies decline to the point where they are worth a lot less (we could say "collapse" to the point of being "worthless" but again, Christmas), the value of the government deficits, all that debt, those unfunded liabilities, and that mountain of $700+ trillion of derivatives -- all of which is denominated (i.e. measured) in those currencies -- will also be drastically reduced -- in fact eliminated.
What replaces those currencies in the end will have to be a new and sound monetary system.
The European debt crisis must end just as the U.S. debt crisis must end.
To sum up:
- The slate needs to be wiped clean and a new sound monetary system introduced.
- That will require the elimination of all debt, deficits, unfunded social entitlements, the US Dollar as Reserve currency, and the big one, the $700 trillion of derivatives.
- To eliminate these problems by default and deflation will cause a banking collapse and untold economic pain, leading to riots and political change.
- Politicians are appointed for relatively short terms and opt for the easy solutions.
- While politicians continue to have the ability to create new money at will, they will do so in order to prevent a melt down on their watch.
- Consequently the odds point to governments wiping the slate clean by generating enough new money to eventually destroy their currencies.
What the new monetary system might look like is a subject for another time. For now, I said I'd keep this letter short and sweet and would finish up 2011 with some thoughts about Christmas from the author of that most beloved of Christmas stories. I hope Part 3 of our analysis of the European debt crisis was short enough, even if not all that sweet. Now it's time for a little Dickens.
A Different Christmas Story by Charles Dickens
We all know Charles Dickens' great story, A Christmas Carol, about how Scrooge discovers the real meaning of Christmas. But Dickens loved Christmas and wrote more about it. Here are some thoughts inspired by his lovely story, "What Christmas Is As We Grow Older." (Dickens' words are in italics.)
Every Christmas I helped my Dad set up our Christmas tree. One of my jobs was to place our little manger scene -- a modest wooden stable whose front folded up -- under the tree. Compared to most nativity scenes, this one was a trifle, but I loved it.
I remember being very small and the joy of staring for what seemed like hours at that little scene. After a while, it felt like I was right in there, part of the scene. Dickens describes that feeling:
Time was, with most of us, when Christmas Day encircling all our limited world like a magic ring, left nothing out for us to miss or seek; bound together all our home enjoyments, affections, and hopes; grouped everything and every one around the Christmas fire; and made the little picture shining in our bright young eyes, complete...
But soon I couldn't "fit" myself into the scene anymore. The world grew wider as I grew bigger. Christmas was no longer about the joy of getting. I couldn't wait for my older brother to take me shopping in Manhattan to buy presents for my family, especially Mom and Dad. I learned the joy of giving.
Therefore, as we grow older, let us be more thankful that the circle of our Christmas associations and of the lessons that they bring, expands! Let us welcome every one of them, and summon them to take their places by the Christmas hearth...
Eventually, Christmas Eve included one of my brother's Jewish friends. He loved spending the time with us as we opened our presents. At first, it seemed a bit odd. (He was, like my brother, 11 years older than I.) But I noticed everyone in the family welcomed him and enjoyed his company. And so I looked forward to the joy of sharing Christmas Eve with him every year.
Welcome, everything! Welcome, alike what has been, and what never was, and what we hope may be, to your shelter underneath the holly, to your places round the Christmas fire, where what is sits open- hearted! In yonder shadow, do we see obtruding furtively upon the blaze, an enemy's face? By Christmas Day we do forgive him! If the injury he has done us may admit of such companionship, let him come here and take his place. If otherwise, unhappily, let him go hence, assured that we will never injure nor accuse him...
In time I learned that the joy of Christmas could overcome not only the difficulties that inevitably visit us as we grow in our responsibilities, but also troubles of the world, even the sadness of losing those whom we dearly love.
On this day we shut out Nothing!
"Pause," says a low voice. "Nothing? Think!"
"On Christmas Day, we will shut out from our fireside, Nothing."
"Not the shadow of a vast City where the withered leaves are lying deep?" the voice replies. "Not the shadow that darkens the whole globe? Not the shadow of the City of the Dead?"
Not even that. Of all days in the year, we will turn our faces towards that City upon Christmas Day, and from its silent hosts bring those we loved, among us. City of the Dead, in the blessed name wherein we are gathered together at this time, and in the Presence that is here among us according to the promise, we will receive, and not dismiss, thy people who are dear to us!...
And so it will be this year as we visit our family and friends and welcome them into our home yet again. None of the disappointments and difficulties of 2011, none of the world's troubles can lessen the joy that has already begun, as we prepare for and celebrate Christmas.
In town and village, there are doors and windows closed against the weather, there are flaming logs heaped high, there are joyful faces, there is healthy music of voices. Be all ungentleness and harm excluded from the temples of the Household Gods, but be those remembrances admitted with tender encouragement! They are of the time and all its comforting and peaceful reassurances; and of the history that re-united even upon earth the living and the dead; and of the broad beneficence and goodness that too many men have tried to tear to narrow shreds.
(You can read the whole story (It's very short), by clicking here.)
If we let it, the spirit of Christmas that Charles Dickens captures in his writing can change the most difficult experiences of our lives into sources of joy and even turn the worst parts of our world to the Good. As for me, I'm grateful this Christmas for the gift of recalling my first joy of entering that little wooden stable. I wouldn't have that gift of joy had I not written this letter -- so thank you for inspiring me to do so, as you do each month.
With sincere wishes for lots of joy this Holiday Season,
Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952
Email: resposito@lighthousewm.com
