Our favorite little specialty bakery here in New York City —Lloyd’s, the one we told you about a few months back that makes the best carrot cake in the world, just opened a second location. Someone’s doing all right out there. Even better, I found out they make pumpkin pies and pecan pies, an important discovery now that our regular bakery seems to have slipped a notch or two in the pumpkin and pecan pie category these last few years.

Okay, so that wasn’t a riveting macro-economic review, or incisive micro-economic insight, but my take away was that the American economy still works at some level. The folks at Lloyd’s, sensing a demand, are going to address it by increasing supply. I wish them well. We’ll get to the not-so-bright-spot in a moment, after we get back to the business at hand.

Last month we looked at a simple explanation of just how the European debt crisis developed. We left off ready to explain:

• How the European Debt Crisis Must End
• Why it Matters to the U.S.

But an obvious question popped up that needs to be covered first.Remember how ridiculous it seemed that anyone would buy the debt issued by governments in Europe?

These governments not only have too much debt on their books, but they continue to issue new debt. So — get this — they not only can’t pay the interest on the debt they already have issued, but they now issue even more debt. And, of course, they need to pay interest on the new debt too.

Would you lend money to someone who was heavily indebted, couldn’t afford to make the interest payments on their debt, and came to you to borrow more money? Of course not. So who exactly buys this debt issued by these governments?

The answer: banks, specifically those “Too Big To Fail” (TBTF) banks.

We’ll again try to keep this simple, as we did last month. But so that you don’t think that we’re somehow over-simplifying matters, we turn to some comments from a former vice president of the Dallas Federal Reserve bank. In his November 2nd article in the Wall Street Journal Gerald O’Driscoll agrees with what we asserted last time — that the promises of politicians looking for votes lie at the center of this crisis (any specific emphasis in the following quotes will be ours):

…which is exactly what we told you. And being an insider at the Fed, looking at the crisis across the Atlantic from our side of the Pond, he also makes it clear that:

And, lo and behold, O’Driscoll obliges us yet one more time by explaining not only who buys all the debt these governments are pumping out, but exactly why the TBTF banks have felt so confident buying all that government debt that lies at the root of the crisis:

Now, let’s read O’Driscoll’s words again: the banks support the government by purchasing its bonds, and the government guarantees the banks.

While you and I would never consider loaning more money to someone who came to us heavily in debt, whom we already knew couldn’t afford to make the interest payments on the debt they already had, you can see why things are different with government and TBTF (too big to fail) banks.

Remember our discussion about the “Occupy Wall Street” gang a couple of letters ago? Well, here’s an example of how “We the People” play by one set of rules and “they” play by a different set. Except that the OWS folks don’t seem to get the part about the government. They’re obsessively focused on the banks and the rich bankers — you know, the whole 1%-99% thing. (That is, if they’re focused at all.) To understand what’s going on, where it’s going and how it must end, we need to look at both sides of the equation: banks and governments.

Now, while government issuing too much debt and banks buying it with a government guarantee worked for a long time, it’s not working any more. Why? Continuing with Mr. O’Driscoll’s comments:

With people slowly waking up to this scheme, we’ve reached an impasse: game over.

For a long time, the banks who bought this absurd debt were allowed to make believe that they would eventually get 100% of their interest and principle payments. In fact, even when the bond markets started to say that the government debt they held was becoming worth less, the banks were allowed to ignore reality.

Again, you and I couldn’t do this. If I submitted my balance sheet to a bank to get a loan and listed my seven year old Toyota (never mind my thirteen year old Mercedes) as being worth what they were when they were new, no way the bank accepts that value. Why? Simple, the cars are worth a lot less.

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.

So when and how does it end? Unfortunately, my crystal ball consistently clouds up whenever I try to see exactly when we hit the wall of either the European debt crisis or, for that matter, our own debt crisis. Frankly, I’ve thrown the darn crystal ball out at this point. It’s not worth agonizing over exact timing here.

What we can see — and you don’t need a crystal ball for this — is not just how it ends, but how it must end. But before we get to that, let’s make sure we all understand that the European debt crisis does indeed matter to us.

For the bigger picture, let’s continue with Gerald O’Driscoll’s comment that:

…to which he adds:

I think the two key words are “overwhelming” and “interlinked.” It’s critical that we grasp the profound import of these two words.

Overwhelming: We must understand that the debt crisis, like a river which has breached its levees, can no longer be contained.

Interlinked: What happens to the banks in Europe will affect the banks in the United States.

There’s no use beating around the bush about this. Even if the governments and central banks on both sides of the pond could successfully kick the can down the road for months or even years (which I doubt) the endgame has begun for them and for us.

Why for us? Are U.S. banks holding tons of European government debt?

Well, while U.S. banks don’t appear to be holding anything near the amount of European government debt as the European banks — although we can’t be sure about this, since they typically don’t disclose all their holdings — they have sold insurance to European banks to protect them from a default of their own governments’ debt. That’s right. 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.

(Remember that, since the U.S. dollar is still the “reserve currency” for the world, everyone needs U.S. dollars to some degree in order to transact business. To run out of dollars would be like your car engine running out of oil. The engine would seize up and stop working. So just as your car needs oil, banks and businesses who do business internationally need dollars.)

The plan calls for the European banks to later swap back dollars for the Euros the Fed is holding. (The Fed doesn’t need to hold Euros, and the European banks will presumably have enough dollars at some point.) Maybe the scheme will work; maybe it won’t. No one really knows. The Fed also does not publicly disclose exactly what it’s doing, so we don’t know how many of these “currency swaps” it holds.

(Notice how banks and the Fed don’t openly disclose a lot of stuff. Why? Are they hiding something? For example, why don’t European banks — in a world absolutely awash in U.S. dollars — have enough dollars on their own? What’s on their books — or not on their books — that could cause them to be afraid they’ll run out of dollars?)

As for the U.S. banks who have engaged in those “credit default swaps,” it’s all done privately — out of the eye of the public and, to a great extent, their regulators, i.e., without any serious monitoring or regulation.

All this should at least make it clear that there’s no use pretending that there’s any chance that the European debt crisis is not and will not affect the U.S. — which is us.

There’s one more piece on this chess board we need to remove before we can move on to the endgame. But this being Thanksgiving and all, I thought we’d take a quick detour and look at what might be a positive, happy ending to what’s sounding a bit dire. No reason to spoil the holiday festivities at the last minute.

For this, let’s turn to a recent “white paper” by the world’s biggest investment manager, Blackrock. I’m doing this for two reasons.

First, I really do make the effort to see the bright side of the picture. I get no kick from bad news. So for that reason alone I look for the opinions of those who think we’re just a few steps away from things turning out OK. Maybe the keen minds at Blackrock have something to offer us.

Second, what if I’m wrong? Many investment professionals sound like they’ve got all the answers. They know. I’m more concerned about what I don’t know — and I really don’t and can’t know everything. It’s not just a matter of humility; it’s also quite reasonable. How the heck can anyone know everything? Besides, I’ve worked with hedge fund firms — the guys who are REALLY supposed to be smarter than the rest of us — and watched more than one crash and burn because they were married to their own genius. That experience alone keeps me from committing all my money to any one idea or thesis — including my own.

In that spirit, I checked out Blackrock’s “Euro Crisis Fallout and a Call to Policymakers.” Without dragging you through the whole thing, let’s just zero in on their suggested solutions to the European crisis. (After all, if they can solve the European crisis, the connections with the U.S shouldn’t be a problem for us, right?) And while we go through their points, I’ll make my comments based upon the facts and analysis we’ve been discussing.

1. More bond buying by the ECB
2. More details on the rescue fund and less complexity
3. A real debt restructuring in Greece, Portugal and Ireland with private creditor write-downs of 75% to 80%
4. Fiscal discipline without choking off growth

Let’s look at these one by one.

#1 – More bond buying by the ECB

The ECB is the European Central Bank. They are now buying bonds issued by Italy and Spain. Italy and Spain are issuing bonds because they need money. The ECB is buying their bonds because when the bonds are offered on the open market, they won’t sell at the interest rates that Italy and Spain can afford to pay.

For the ECB to do more bond buying than they’re doing now would require them to “print money” (create more money out of nothing, which is what banks do when they “print money”). The German government, the most powerful in Europe, opposes this because the German people remember the catastrophe of the Weimar Republic hyperinflation of the early 1920’s. (Think about this: 90 years later, after most people who lived through it have died, the German people still have a deadly fear of a recurrence of hyperinflation.)

#2 – More details on the rescue fund and less complexity

They’re referring to something called the ESFS bailout fund (European Financial Stability Facility). European countries committed money to this. The money will be used to assist European countries in economic difficulty. The ESFS would issue bonds to raise the needed money.

The ESFS already conducted a bond auction. (Bonds are sold by auction.) The auction “failed.” That means they couldn’t sell all the bonds they had up for auction; they only sold some. There’s no evidence they would do any better if they tried again. But if the ECB can be convinced to print more money — and can somehow overcome German resistance — why would they need to pursue this ESFS “rescue fund” route, something Blackrock already describes as too complex?

#3 – A real debt restructuring in Greece, Portugal and Ireland with private creditor write-downs of 75% to 80%

They’re suggesting that the bonds that have been issued by these three countries are relatively worthless and any bank (the “private creditor”) that bought them should once and for all recognize this and stop pretending they’re holding something that has any value. A simple word to describe these “write-downs” is “default.”

If Greece, Portugal and Ireland defaulted on their bonds, it would be ugly but not the end of the world. These three economies are small, in relative terms. The real problem would be Italy and Spain — the current concern. The Blackrock folks assure us that it wouldn’t be a problem until February — three months from now. After that, the ECB would step up and buy more Italian bonds. That brings us back to #1, where the ECB would print money.

#4 – Fiscal discipline without choking off growth

This means that too much of those “austerity measures” you’ve read about will simply shut down the country upon whom these are imposed. The reason that Greece, for example, has resisted further austerity measures is that the original measures have pushed the country into a depression and the depression will only get worse with more austerity. So out with the austerity measures and in with something called “fiscal discipline.”

If Greece, Portugal and Ireland default, as Blackrock suggests, those countries get to drop the austerity measures that have their economies in a funk. They won’t have to pay the interest or, of course, the principle on those defaulted bonds. But this still leaves Italy and Spain (and who knows who else?). Go back to #3 and we see that Italy’s got enough cash flow to cover about 3 months of expenses. After three months, the only way they could avoid austerity measures would be if they defaulted on their bonds too. But Blackrock recognizes that Italy (and Spain) cannot be allowed to default on their bonds. They’re too big for the “too big to fail” banks that hold their bonds. If the too big to fail countries in Europe (TBTFCIE?) fail, the TBTF banks would fail. . So the only way to prevent all that from happening would be to, again, go back to #1: The ECB has to print money.

As for this “fiscal discipline” approach. Blackrock doesn’t define what they mean. But if we stick with Italy, we know that theItalian economy has seen essentially no growth for the last ten years. And they certainly did not exhibit much fiscal discipline during that time. Black rock suggests that Italy should start now. Good luck.

To sum up in the quickest and simplest way, all you have to do is look at the common thread in each of these four points. By hook or by crook, Blackrock wants the European governments to continue to issue more bonds and the European Central Bank to print more money.

Would this resolve the crisis? I suggest it will simply stop the madness for a while. How long, I can’t say. For any real resolution, you have to count on countries that haven’t exercised fiscal discipline for decades to do so now. Unless Blackrock has some magic formula for fiscal discipline that hasn’t been thought of before I can’t imagine them starting now.

Short of that magic formula, our analysis suggests it’s too late for fiscal discipline. If, as we explained last time, governments always grow bigger and politicians aren’t willing to confront their citizens with the bad news about how they promised more than they could deliver — for decades — then there won’t be any fiscal discipline, certainly not using any definition with which I’m familiar.

Well, give the Blackrock folks credit. Their business relies on people feeling good, because it’s only when people feel good that they buy financial products and services. And Blackrock — the world’s largest investment management firm — certainly has lots of that. But rather than having to explain why I think that a lot of research and analysis by Wall Street firms tends to be self-serving, I simply point to the “conclusion” of the white paper:Global equities look attractive. Yes, that’s the conclusion they draw at the end of the paper. I’d explain how this fits into the theme of the paper, but frankly the connection escaped me.

Next month we conclude our journey into the European debt crisis. While I realize this is taking a while to unravel, I can assure you that next month you will understand exactly how the European debt crisis must end.

For now, all I can say is that we’re just about ready here at Casa Esposito for the arrival of family members making, for some of them, a rather long trip to share Thanksgiving with us. I don’t need much more than that to be thankful.

Whatever you’re doing, I hope you have reason to be thankful too. And while we haven’t found much to be thankful for in our discussion of the European governments, big banks or even the world’s biggest investment manager, I don’t want to leave you on a sour note. For something uplifting, we turn from the biggest investment manager in the world to the biggest recording artist in the world.

It turns out that this incredible Greek performer sings not just in Greek, but in Italian, Spanish, even German in a delicate and beautiful voice. (Anyone who makes German sound delicate gets my vote as incredible.)

I suspect most Americans have never heard of her. These days, most Americans I know don’t have much positive to say about Greeks. But as I listened on Youtube, I started thinking about how this Greek artist was able to bridge the boundaries between countries and cultures with her God-given gift for all these years. Her music is absolutely adored in Europe. I was also reminded of how the European civilization that finds itself in such a mess today can trace its philosophical, religious and scientific culture to the Greeks. Meanwhile, while watching and listening to one lovely performance after the other, the terrible history of European wars, and the more recent history of daunting economic crisis simply faded into the strains of her lovely singing.

I hope you find some time to spend with Ms. Maskouri on Youtube if you have a spare moment or two during the long holiday weekend. To encourage you, I’ve included a link to a performance by Nana of one of the world’s most beautiful and beloved songs. I picked a “live” version of this, rather than the studio version, in spite of the imperfections of the video and the audio because seeing her sing this will only add to the immense joy of simply listening. If you’re willing to give it four minutes of your time, just click here.

The ancient Greeks, among other things, were the first to attempt to define the Beautiful. They could have used Nana Maskouri as an example had she lived then. In any case, you may find yourself as thankful as I did for those Greeks and for Nana Maskouri.

Happy Thanksgiving!

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