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Europe’s Trillion-Dollar Bailout - Can It Work?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 25, 2010

IN THIS ISSUE:

1.  US Taxpayers Bailing Out Greece & the Rest of Europe

2.  Quick History of the International Monetary Fund

3.  IMF Prepares for $1 Trillion Bailout of Europe

4.  EU Bailout Approved, But Will It Work?

5.  Will Any of this Money Ever be Paid Back?

6.  The “Cornyn Amendment” – A New Monkey Wrench

Introduction

On April 12, the International Monetary Fund (IMF) increased the capacity of its emergency lending fund from $50 billion to $550 billion, a ten-fold increase, and may increase it to $750 billion if needed.  The IMF’s director stated in his press conference that the additional funding would “ensure that the Fund has access to adequate resources to help members that are vulnerable to financial crises.”

In order to increase this emergency funding by half a trillion dollars (or more), the IMF moved to significantly increase the lending commitments of its member nations, of which the largest contributor is the United States.  Oddly, there was very little talk about this in the mainstream press.  I will discuss it in more detail as we go along.  Upon learning of this huge increase in IMF funding in April, I thought to myself that the IMF must see something very scary in the near future. 

Scary indeed.  On May 9, the European Union announced a near $1 trillion bailout package for euro-zone countries in an effort to address the “sovereign debt” crisis that began in Greece but now threatens the stability of financial markets across the region.  Interestingly, of the near $1 trillion bailout, apprx. $640 billion will come from EU member countries, and apprx. $320 billion will come from the IMF.  This obviously explained the need for the IMF to dramatically increase its emergency lending fund in April.

I find it more than coincidental that the near $1 trillion bailout of Europe came on the very weekend following Thursday, May 6 and Friday, May 7 when stock markets tumbled around the world, including the near 1,000-point intra-day plunge in the Dow Jones on May 6.  Stock markets around the world rallied briefly after the massive European bailout was announced, but most equity markets came back under downward pressure soon thereafter.

The question is, will this massive bailout work?  There are many reasons why it probably will not.  Perhaps the simplest observation is, how can countries that are already running huge deficits borrow their way out of a financial crisis?  But that is exactly what our own nation is doing, so we should not be surprised that Europe is following our lead.  I believe this will come to a very ugly end in the next several years.  Alas, here are the latest developments.

US Taxpayers Bailing Out Greece & the Rest of Europe

As noted above, there was very little attention paid by the mainstream media to the IMF’s decision to increase its emergency lending fund by ten-fold or more in April.  While the European Union’s announcement of the latest $1 trillion bailout on May 9 did make news, most Americans paid little attention because it is euro-zone countries that will be borrowing the money.  Many Americans thought, Hey, it’s a European problem, what do we care?

Many Americans didn’t stop to think that the IMF will be loaning apprx. one-third of that $1 trillion to the European Union, and the US is the single largest contributor to the IMF.  To that extent, US taxpayer dollars are going to be a big part of the bailout for Greece and any other EU countries that get into trouble and need bailout money.   

Even before the $1 trillion bailout that was announced on May 9, the US had already contributed to an IMF loan directly to Greece totaling apprx. $40 billion, along with another $105 billion in direct loans to Greece from several euro-zone countries.  The US share of the $40 billion was reported to be in the $6-7 billion range.  These initial loans were announced on May 2.

And it gets worse.  Over 20% of the $500 billion of additional borrowing the IMF recently authorized will come directly from the US.  Yes, the US is putting up over $100 billion in taxpayer money toward that extra half-trillion dollars in new IMF funding.  Since most Americans are not very familiar with the IMF, much less how it is funded, they have no reason to be aware that they are on the hook for this money.

And it gets even worse.  The US Federal Reserve reopened its so-called “swap lines” of credit to major foreign central banks on May 9.  These swap lines allow foreign central banks to exchange their own currencies (including euros) for US dollars if need be, this time in unlimited amounts.  As this is written, it is reported that the Fed has lent over $10 billion to foreign central banks since it reopened the swap facility earlier this month.

Quick History of the International Monetary Fund

Since US taxpayer money is being used to bail out Greece, vis-à-vis the IMF, perhaps a brief history of the International Monetary Fund is in order.  The IMF was formed in July 1944 in the wake of WWII.  Initially, it consisted of 45 countries and its original mission was to stabilize global exchange rates and head up the reconstruction of the world’s international payment system.  Member countries contributed money to a pool which could be borrowed from, on a temporary basis, by countries with payment imbalances.

Since its founding, the IMF has grown to include 186 member nations, all of which contribute annual quotas to pay for the organization’s expenses and lending.  The US is the largest single contributor nation, funding apprx. 17% of the IMF’s annual budget of $330+ billion, which doesn’t include the latest $100 billion infusion discussed above.

Today, the IMF describes itself as “an organization of 186 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty.”  As the Great Recession and the financial crisis unfolded and played out, the IMF experienced sharply increased demand from member nations for loans and other financial aid.

The IMF issues its own international reserve asset (currency) known as “Special Drawing Rights” (SDRs) that can supplement the official reserves of member countries.  SDRs are a basket of currencies that today consist of the euro, Japanese yen, pound sterling, and the US dollar. Their value is calculated as the sum of specific amounts of the four currencies valued in US dollars, on the basis of exchange rates quoted at noon each day in the London market.  IMF members can voluntarily exchange SDRs for currencies among themselves.

At the G-20 summits in London and Washington last year, world leaders discussed the IMF’s need for significantly more capital in the wake of the global recession and financial crisis.  The idea of an additional $500 billion (or even more) in IMF funding was tentatively approved, subject to the approval of and adoption by the IMF’s Executive Board, which formally occurred last month on April 12. 

IMF Prepares for $1 Trillion Bailout of Europe

While the mainstream media paid little attention to the IMF’s massive $500 billion money grab, I could not help but wonder if the IMF Executive Board was seeing some very dark clouds on the horizon.  It didn’t take long to find out what the IMF was preparing for.

As noted above, on May 9, the European Union announced a near $1 trillion bailout fund for euro-zone countries in an effort to address the “sovereign debt” crisis that began in Greece but now threatens the stability of financial markets across the region.  Of the near $1 trillion bailout, roughly one-third of that amount, apprx. $320 billion, will come directly from the IMF.  EU member countries will contribute apprx. $640 billion toward the historic bailout. 

This explains the need for the IMF to dramatically increase its emergency lending fund by $500 billion or more in April.  Again, the US is contributing over $100 billion (or more than 20%) of that historic IMF funding.

According to European Union spokesmen, the near $1 trillion bailout fund will be used, not just for Greece, but also for any other euro-zone countries that may get into trouble.  In addition to Greece’s plight, Portugal, Italy, Ireland and Spain are also experiencing serious financial troubles of their own, and may also require bailouts.  These five countries have come to be known – aptly so – as the “PIIGS.”

Interestingly, President Obama played a role in pushing through the $1 trillion bailout for Europe.  Of the euro-zone countries, Germany is the largest and is in the strongest financial position.  German Chancellor, Angela Merkel, and her cabinet were strongly opposed to participating in the trillion-dollar bailout until just recently.

White House Press Secretary Robert Gibbs reported on Monday, May 10 that President Obama called Angela Merkel several times over the weekend of May 8-9, urging her to agree to the near $1 trillion bailout package.  According to the New York Times, Mr. Obama was on the phone with the German Chancellor on May 8-9 “offering urgent advice” and “some not so subtle prodding” that Europe needed an overwhelming rescue package of the sort Washington came up with in 2008.

German voters were outraged that Merkel agreed to the bailout.  In regional elections over the same weekend, Merkel’s conservative-liberal coalition was trounced.  The election result stripped her government of its majority in the country’s Bundesrat (German senate) and her ability to pass reforms cutting public spending.  Despite the public outcry, the German parliament voted in favor of its part of the massive bailout, which could require German monetary commitments of $150 billion and, conceivably, even more.

EU Bailout Approved, But Will It Work?

Americans are deeply divided on the question of whether or not President Obama’s now $862 billion stimulus package in 2009 really worked to revive the economy and the financial markets.  Obama claims it has worked, but the most recent polls I’ve seen suggest that more Americans think the massive stimulus has not worked.  And a large majority of Americans, some 84% or more, based on the latest FOX news poll, are deeply concerned about our trillion-dollar budget deficits as far as the eye can see.

Likewise, in Europe many voters there have misgivings about the trillion-dollar bailout working.  These concerns come mostly from citizens of the EU countries that will have to pony-up the money to bail out Greece and possibly others among the PIIGS.  The main concern – that I would agree with – is that you don’t solve a debt crisis with more debt.  But just like America has done, Europe is going to try it anyway. 

Then there are the purely economic concerns.  In return for the bailout, Greece has been forced to accept and implement very harsh austerity measures.  Wages, bonuses and pensions have been cut.  A hiring freeze is in effect for government workers, and the government doubled the limit of allowable monthly worker layoffs in private companies (they regulate these kinds of things in Europe).  The Value-Added Tax has been increased, along with personal income taxes. These are just some of the recent austerity measures.

The goal of these measures, in addition to qualifying for the bailout money in the short-term, is to cut Greece’s annual budget deficit to only 3% of its GDP by 2014, down from 13.6% at present.  Unfortunately, all of these austerity measures have thrown the Greek economy, which was already in a recession, into a depression that will likely last for several more years.  As Greece’s GDP shrinks rapidly, it will be virtually impossible for Greece to get its deficits down.

We’ve all seen the videos of angry mobs rioting in the streets of Athens.  This raises odds that the Greek people will vote out the current officeholders and vote in new leaders that will reverse the harsh austerity measures.  This same risk will be present with the other PIIGS should they have to qualify for bailout money. 

While the trillion-dollar bailout may make things better financially in the short-term, there is no assurance that Europe won’t face another even greater financial crisis a year or two or three down the road.   The same is true for the US.  And the next one will almost certainly be a global crisis that could result in a depression, as I wrote in my March 23 E-Letter.

Will Any of this Money Ever be Paid Back?

The euro rallied on Monday, May 10, after the announcement of the $1 trillion European bailout, but it has since fallen to a four-year low against the US dollar.  Most analysts expect the euro will continue to fall in the months ahead.  And why not?  Virtually no one believes that these trillions of dollars of bailouts (in the US & Europe) will ever be paid back.

As I have written at length in recent weeks, there are similar concerns that the US will never repay the tens of trillions that are likely to double our national debt over the next 5-10 years, assuming Obama continues to run trillion-dollar annual budget deficits, as projected.

With Europe’s latest trillion-dollar bailout, the EU is jumping into the same boat as the US did soon after Obama took office.  No one knows what the long-term effects will be, or if these massive bailouts will lead to yet another financial crisis of epic proportions (ie – another depression at some point). 

Just a couple of years ago, the value of the US dollar was plunging to new lows, and the euro was soaring to new highs.  There was even talk of the euro replacing the US dollar as the world’s “reserve currency.”  Well, forget that.  In light of the European financial crisis, the euro is basically toast.  It may not survive the current financial crisis sweeping across Europe.

Worst of all, it appears that the various loans comprising the $1 trillion bailout package for Greece and the other PIIGS will be subordinate to Greece’s current lenders.  And who might those earlier lenders be?  It is widely reported that a large part of Greece’s outstanding debt (Greek bonds, notes, etc.) is held by large commercial banks across Europe and euro-zone investors.

If the $320 billion that the IMF has pledged to the bailout will be “junior” to Greece’s current bondholders, then we can kiss that money goodbye!  It was probably gone anyway, but the IMF should have insisted that its loans be put in first lien position.  But it now appears that the new loans may be “last in, last out.”  If it’s true that the trillion-dollar bailout will largely go to let European banks and fat-cat investors off the hook, this is appalling!

I could go on and on with this discussion and the long-term implications for the world financial markets, but space does not permit.  Also, there are late-breaking developments that could change everything, so I will close out this week’s letter with the latest “wild-card” in this race to bail out Europe.

The “Cornyn Amendment” – A New Monkey Wrench

On May 12, Senator John Cornyn (R-TX) introduced an amendment (SA 3986) to the massive financial regulatory reform bill that has been working its way through the Senate for the last several weeks.  The Cornyn amendment would place new restrictions on US-funded bailouts of foreign nations, and the amendment passed on a bipartisan vote of 94-0 last week.  Then the financial regulatory reform bill passed the Senate last Thursday night, including the Cornyn amendment.

Specifically, the Cornyn amendment requires the Obama administration to evaluate any proposed bailout of a foreign nation where that nation’s public debt exceeds its annual Gross Domestic Product (GDP), and then to certify to Congress whether the bailout loan will be repaid. If the Administration cannot certify that the bailout loan will be repaid, it will be required to oppose the bailout and vote against it at the IMF.  Wow!

But before we get too excited about this development, we need more detailed information.  As this is written, there has not been much talk about it, other than the fact that it passed, and that the financial reform legislation passed, which included the Cornyn amendment.  For example, we don’t know what kind of “teeth” the amendment has, when it goes into effect, etc., etc.  I question this because I have no idea why so many liberal Democrats voted for it.

With what little we do know, it would seem that the US would have to vote no on the IMF’s participation in the near $1 trillion bailout for Europe and Greece in particular.  Greece’s current public debt is about $395 billion or 124% of its Gross Domestic Product.  After the bailout, Greece’s public debt is forecast to rise to more than 150% of its GDP in 2014.  So, based on what little we know about the Cornyn amendment, it would appear that our US representative in the IMF would have to vote NO on the European bailout.  [More details to follow.]

FYI, the Congressional Budget Office estimates that US public debt will reach 90% of GDP by the year 2020, based on President Obama’s budget forecasts.  But as most readers know, I believe those CBO projections are based on far too optimistic economic assumptions.  For one thing, the CBO assumes there will be no recession in the next 10 years, but I disagree. 

The point is, the US could find itself ineligible for a bailout under the Cornyn amendment at some point if Obama and future presidents continue to run trillion-dollar budget deficits.  Of course, by that time, there will be no one left to bail us out.  We are on track to be another Greece, only amplified greatly, sometime in the not too distant future. 

Of course, all of this assumes that the Cornyn amendment remains in the final financial reform bill after it is reconciled with the House version.  Don’t be surprised if the Cornyn amendment is dropped altogether.

Conclusions - Fear of Contagion

With the equity markets currently in a downward correction phase, largely due to the problems affecting the euro-zone, we are again seeing the effects of contagion.  The concept of contagion simply means that problems in one market or region of the world can affect economies and markets in other parts of the world.

The subprime mortgage crisis is the poster child for a global contagion.  Despite assurances from some of the smartest economists in the world that the subprime market simply wasn’t big enough to have much of an effect, it eventually wiped out trillions of dollars of wealth in the stock markets and hit some foreign markets even harder than those in the US.  Investors remember all too well how the assurances of the “experts” proved to be wrong, resulting in huge investment losses all across the globe.

The problem now is that any similar assurances about Greece and the other PIIGS is taken with a huge grain of salt by global investors.  Could the Greek sovereign debt crisis explode into the next global asset meltdown?  As usual, many of the talking heads say no, but the average investor isn’t convinced, and I don't blame them.

Fear is again driving the market.  Retail (mom and pop) investors had been slowly creeping back into equity mutual funds through the end of April, based on statistics published by the Investment Company Institute.  However, with the growing euro-zone uncertainty in May, equity mutual funds have started to again experience large outflows.  In fact, even bond mutual funds are now seeing net outflows of funds, reversing a year-long trend.

Investors, fearing a repeat of the subprime contagion, are bailing out of mutual funds in favor of cash assets.  Evidently, investors are looking at both the domestic and international sovereign debt situation and are realizing that you can’t cure debt with more debt, and are voting with their feet.  Too bad our elected officials are oblivious, for now, and can’t seem to learn that lesson.

Best regards,

Gary D. Halbert

SPECIAL ARTICLES

The World is Dangerously Exposed to European Default
http://blogs.ft.com/brusselsblog/2010/05/world-is-dangerously-exposed-to-european-default-report-says/

Are Muni Bonds the Next Financial Landmine?
http://www.time.com/time/business/article/0,8599,1991062,00.html

Don’t Rule Out a Double-Dip Recession
http://online.wsj.com/article/SB10001424052748704852004575258332608266808.html

Washington’s $1 Trillion Opportunity
http://online.wsj.com/article/SB10001424052748704113504575264463277182700.html?mod=WSJ_newsreel_opinion


Read Gary’s blog and join the conversation at garydhalbert.com.

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