The wolf in the woods

SUBHEAD: Poor little Red Riding Hood, the economic forest seems denser and darker all the time.  

By Ilargi on 21 December 2011 for the Auomatic Earth - 

Image above: A contemporary Red Riding Hood and the big bad wolf. From (

Haven't we been here before?  

Fairy Tales
It's the sort of question you would expect a child to ask in one of those Grimm Brothers fairy tales, a young girl walks so far into the woods that she gets lost. She begins to leave a trail of breadcrumbs behind her but takes another wrong turn and then another while the forest feels denser and darker all the time. She may have circled and crossed her own path but doesn't know it, because the breadcrumbs have been eaten by the animals. And then the night decends.

That's how I increasingly picture our financial situation. We march forward full of feigned faith and innocence into uncharted territory, telling ourselves we will and must find a way out of this mess, boosted by the high priests of our economic belief systems, the media, economists and politicians. The children in the fairy tales always escape from the darkness in the end, but we're not those children. Ignoring the warnings and getting lost in the woods is not an act of bravery, but one of stupidity.

Characters in fairy tales serve to teach their young listeners a lesson about the morals of their societies; these characters don’t perish, they get saved because they see the errors of their ways in time. A morality tale. But whereas the children in these fairy tales go gently into a good night, we go blindly into a bad one.  

Euro woes
Perhaps it's fitting that this time around the economic rally came before instead of after the announcement by Mario Draghi, president of the European Central Bank (ECB) the offer of €489 billion in cheap loans for European banks. It fits right in with all the other things we get totally the wrong way around. About 60% of those loans, by the way, are just regurgitated old stuff. Looking even briefly at what they have come up with in 1001st episode of the bailout drama, there's one conclusion and one only: what they say is not what they think. The ECB claims that it "hopes" the banks will use the money to purchase peripheral debt, but the ECB knows they won't - and what sort of €489 billion deal depends on "hope" alone? The ECB knows, because the ECB itself, along with other parties, has refused to guarantee that debt.  

Return on Risk
It may be presented as a good deal, but borrowing at 1% to get a 5% return is not all that attractive when you have a 50% chance of an 80% haircut. Or something along those lines. The ECB also said they hope banks will use the money to loan out to consumers. That's just as big a pile of dog doo-doo. Banks are shedding assets like they're fleas, because they need reserves. That points to a solvency issue. But being able to borrow at ever cheaper rates while handing out ever more doubtful collateral addresses what is a liquidity issue.

There are a few things that this sort of lending will indeed achieve. It will gobble up bad assets from private banks and transfer them to the risk of the public coffer. Nothing new there. The child just gets deeper into the forest, and the light starts fading. A step by step process perceived as progressing so slowly, it raises no alarm. It's still morally repugnant, but whoever is in charge of this thing doesn't have any morals left anyway.

Another effect of that €489 billion in loans is that it will widen the divide between the ECB and Germany, in particular its central Bundesbank - and substantially so. This effect endangers the entire Eurozone project. Whatever plan Europe comes up with, be it the European Financial Stability Facility or the European Stability Mechanism, or this latest one from the ECB, there are only two countries left to carry the vast majority of the risk. One of those countries, France, will soon be downgraded. So will its banks. This will lead to a downgrade of the EFSF and, if there's still time, the ESM.  

Germany alone At that point there will be only Germany left to carry the entire burden on its shoulders. Germany's allies and relatively strong partners, Holland, Finland, are way too small to do any heavy lifting. Moreover, Holland is on the verge of a housing collapse. The EFSF needs to be funded; it can only spend what it has received.

Europe has been unable to agree on expanding the Facility. Which is why the ECB now comes with its loan plan. Which did lead to a market rally, but that rally fizzled as soon as the plan was announced, even though it was at least €100 billion larger than expected. So France soon will no longer be a net contributor to the EFSF. Which is one of the main reasons the expansion didn't materialize.

Hence, it's all Germany's responsibility, and Germany is smart enough to understand it's not strong enough to bear that responsibility. And then out of left field comes Mario Draghi handing out half a trillion euros in loans to 523 different European banks that on average are just about to draw their last breath.

Those banks are selling off their profitable assets because that's all buyers are interested in. The lousy assets they couldn't sell they now can pledge to the ECB, with a huge chunk of the risk involved landing squarely on the shoulders of the German citizenry. The chance that Berlin will now look more seriously at cutting its losses while it can has become much bigger after Mr. Draghi's first substantial act as ECB president. It's deceptively simple, really. Germany can't guarantee Greek and Italian and Spanish debt while France awaits slumping badly in the wings. Germany would be risking its own wealth, and its own coherence as a society, in the process.  

Meeting the wolf
 Staying in the metaphor of the child lost in the darkening forest (and yes, the Grimm brotheres were German), it's like the young girl, after taking yet another wrong turn, has stumbled upon a big bad wolf. And though it's already getting almost too dark to see, the last thing the child does notice is that the wolf looks nothing like its sweet old grandmother.


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