Overview

To “save” the euro, the European Central Bank (ECB) chose what some economists were calling the “nuclear option”. That sounds dramatic, but for non-economists: what does it mean? Why was Germany so strongly opposed? As we will review herein, the ECB’s choice of the “nuclear option” means: 1) the door has been opened for unlimited direct monetary creation by the ECB; 2) the money will be effectively used to pay for an outside-the-budget, unlimited bailout of major European and global banks; 3) the inflationary effects of creating all this new money will be contained by creating still more money out of the nothingness; and 4) as part of their Faustian bargain, global banks will hollow out still more of their balance sheets, growing ever economically weaker even while their regulatory capital creates an illusion of ever greater strength.

The European Central Bank had a blueprint from which to work: the parallel interventions by the Federal Reserve in the United States. As it happens, I've recently finished a series of articles that explain the Fed’s blueprint for creating a financial nuclear device. In this article we will summarize the path chosen by the ECB, and briefly discuss the key implications for investors. Each summary will also link to a full length educational article on the particular implication in question.

There are three powerful incentives for US readers to understand the contents of this article. 1) In this tightly interlinked world, if the European economy plunges down – so does the US economy. 2) We’re the blueprint, and face quite similar risks. 3) There he goes again! Ben Bernanke just bravely stepped forward to once again take on unlimited risks for the citizens of the United States, this time in the form of currency swaps, thereby imperiling the value of our money and savings.

Two Bailouts

The starting point for deciphering what just happened in Europe is to understand that we have not one, but two bailouts going on. There is the approximately $1 trillion (750 billion euro) loan package put together by European Monetary Union members as well as the International Monetary Fund. Sometimes referred to as the “shock and awe“ rescue package, it was unveiled at 3:15 AM in the morning, after a marathon 14 hour meeting among European financial chiefs.

The other bailout was (as in the United States) the real bailout, the one that really matters, and there is no price tag put on it. There is no price tag because there is no limit on what can be spent. "The European Central Bank said it will buy government and private bonds as part of an historic bid to stave off a sovereign debt crisis that threatens to destroy the euro" (Bloomberg). This type of purchase was prohibited when the ECB was created – because of its potentially dire inflationary consequences.

Bailing Out Banks Through Direct Monetary Creation

To understand the rescue, we need to understand who the beneficiaries are, and Greece is arguably not the main beneficiary. For the European Central Bank is not buying the securities directly from the governments or the private issuers -- it's buying them from the banks. The banks are in deep trouble, so the European Central Bank takes its power – which is the stewardship of the value of money for the citizens of Europe – and uses this power to buy the banks out at on an unlimited basis. The pricing is more attractive than what the market offers (which is the point of the intervention). So the banks either don’t lose money at all, or they take much lower losses than they would through selling to normal buyers. The ECB is making an unlimited amount of banking losses disappear. As others have commented, the euro zone rescue plan is not really a bailout of Greece, but rather, a bailout of Europe's (and America's) banks.

For more on the blueprint mechanics of how a central bank can pay for outside-of-the-budget bank bailouts without limit, through the creation of money without limit, please read the article linked below, “Creating A Trillion From Thin Air”.

http://danielamerman.com/articles/Trillions.htm

The “Sterilization” Of The New Money

Of course, creating money without limit to fund bank bailouts without limit would usually have the nasty side effect of leading to immediate and powerful inflation. So the central bankers of Europe faced the same dilemma as did the Fed in the US: how do we spend unlimited money but contain the immediate inflationary effects?

Following the lead of the Federal Reserve, what the European Central Bank will do is to attempt to “sterilize” the money, by offering to purchase bonds without limits, but keeping the money paid out from leaving the ECB and entering general circulation. The particulars have yet to be announced, but for a good guide to how “sterilization” works, please read the article linked below: “Containing Inflation Via Unlimited Money Creation”.

http://danielamerman.com/articles/Containment.htm

Banks have the right to take the newly created money paid to them for the bonds, and go lend it out at any time (which is what banks are supposed to do with their money), but this would likely lead to immediate rampant inflation. To keep the banks from doing so, as described in my article above, essentially a corral is formed to keep the euros from leaving the central bank. The corral is created of money, and consists of paying the banks to not pull their balances out. Because the European Central Bank has unlimited monetary creation ability, it can pay however much money it needs to keep the bank money (that was used to pay for the bonds) out of circulation. Even if a “horse” does succeed in jumping the fence, and a bank takes its money out, there are a variety of lassos the central bank can use to pull the money back out of the system, as described in the article.

So what the coldly clinical term “sterilization” means, effectively, is that unlimited money can be created and passed to privileged insiders, keeping the major investors from recognizing the losses from their bad investments, so long as the central bank is willing to create unlimited additional money to keep the original created money from “escaping". You don’t need to be an economist to understand the hubris involved here, and how dangerous this desperate strategy is for all of us.

Creating An Artificial Securities Market

The initial response to the euro zone rescue was enthusiastic, and why shouldn't it be? The banks of Europe and the world had just been assured they would be the beneficiaries of a virtually unlimited bailout, and that news was worth celebrating when compared to the alternatives of paying the price for bad investment decisions. However, even within 24 hours, some of the enthusiasm was cooling off, and the reason is that the fundamental problems haven't changed.

As covered in my article linked below, “Futile Attempts To Reflate The Housing Bubble”, the US has its own parallel fundamental issue with mortgages and the housing market (as well as its even bigger “sovereign debt” problems). The consequences of dealing with that failure in the housing market was something that the politicians and bankers were unwilling to accept, as full acceptance of what is happening would likely shorten all of their individual careers. Thus, desperate measures were taken, supposedly to buy time. These measures do buy time for politician and banker careers, but they don't buy society anything, as the “cure” effectively risks the value of all of our savings in order to accomplish the goal of creating a bookkeeping illusion.

http://danielamerman.com/articles/Reflatea.htm

The creation of money without limit does not cure the fundamental issue of governments making promises which they can't possibly afford to keep. Europe’s sovereign debt crisis is still there. Greece hasn't cured anything. Portugal, Spain, Ireland, and Italy all have their own oncoming issues. As do the stronger European economic powers when we travel another 10 or 15 years further out the demographic cycle.

In Europe and the US, the central bankers rationalize their actions by saying that they give time for normality to return. With stability and time, so we are told, normal pricing will return, our current global problems will go away like a bad dream, and as the US mortgages and European bonds pay off, the “sterilized” trillions are removed from bank balance sheets, until they have disappeared as completely as if they never they existed. And we've all been bailed out at no cost to any of us, thanks to the brilliance of our courageous central bankers.

It is a lovely sounding fairy tale, but unless the governments of the world somehow find the ability to cure their sovereign debt crises, the fairy tale will not have a happy ending. Instead, the problems will just get worse and worse, which will mean that government interventions must continue on a massive scale to maintain an artificial market. Which will mean more and more money must be created out of thin air -- until a breaking point is reached.

Hollowing Out The Banking System

What has been little recognized is that in making their Faustian bargain with the world's central banks, the global banking community has had to sell not their souls – but their balance sheets. Yes, the festering wound of government and private bonds that had been plunging in value has been removed from the banks’ balance sheets, seemingly without cost to the banks or society. However, as always in real life, there is a cost. The price can be found in that sterile place known as central bank reserve balances, as explained in the article “Hollowing Out America's Banks".

http://danielamerman.com/articles/Hollow.htm

From an accounting and banking regulators’ perspective, balances held at a central bank, whether it is the Federal Reserve or the European Central Bank, are about the safest investments a bank can possibly have. However, these investments are, in economic essence, investments in nothing at all. There is no real economic activity. The source of security is the central bank’s control over the money supply, its ability to create money out of nothingness as needed. So what bailing out banks on a massive basis with “sterilized” central bank money (which can’t actually be spent) truly means is that distressed assets that represent investments in the real economy are systematically swapped out for economically unreal claims on monetary creation authority. In economic terms, the banks become steadily weaker, even as their strength appears to grow when viewed from a regulatory and accounting perspective.

The Fed Volunteers To Take Still More Unlimited Risks

This next level is where the crisis in Europe becomes even more deeply intertwined with the financial crisis in the United States. Part of the rationale for the Federal Reserve's creating an entirely artificial $1.25 trillion mortgage market, is that bank balances at the Federal Reserve are effectively collateralized by all the (below market) mortgage securities it now owns. It is these valuable mortgages that will pay off the bank reserve balances, or so the theory goes. Just as in theory, the cash flow from the bonds that the ECB purchases will be used to eventually wind down the “sterilized” reserve balances.

As I explained in my article linked above, “Hollowing Out America's Banks”, the problem with this theory is the multitude of other crises that the Federal Reserve is taking on. The bank depositors and shareholders may have to wait their place in line for whatever's left over after the Fed has also bailed out the United States government, the state governments, the global derivatives crisis, then whatever else the Federal Reserve decides is in need of fixing with its unlimited monetary creation ability.

A very significant demonstration of this problem can be found in the United State’s role in the euro zone economic rescue. Ben Bernanke, chairman of the Federal Reserve, has volunteered to enter into dollar swaps as needed, to help out the European Central Bank. What this means is if the ECB wants to buy distressed government and private bonds with dollars instead of euros, the US central bank (the Fed) agrees to help them do so, by swapping dollars and euros. So if the euro collapses – the Fed (and the US) takes the hit on those swaps, instead of the ECB.

The dollar amounts are unknown, but the last time this happened in 2008 and 2009, the Federal Reserve ended up removing all limits, with a total swap volume that ended up peaking at $583 billion in late 2008. If a similar volume occurs this time (it could be less – or much more), that is half a trillion dollars of risk that the Federal Reserve is agreeing to cover, in case the euro plunges in value relative to the dollar.

This is on top of all the other massive and unprecedented risks that the Federal Reserve is taking now, or may take in the future. Thus, the cash flows from that trillion dollars in below-market US mortgages just got another claimant. Even as the risk of inflationary meltdown for the US dollar – with devastating damage for US savers and investors – increased another notch.

Offering a half trillion in help to a buddy in need may or may not be the correct political and economic choice. But what needs to be clearly understood is that this is yet another very real and massive risk that the Federal Reserve is taking, without benefit of Congressional approval, or inclusion in the budget. The only source of repayment is the Fed’s ability to create more dollars. Which means the ultimate value of the dollars you and I have, is potentially significantly less today than it was last week.

Financial Nuke Blueprint Summary

Here’s a quick summary of the Federal Reserve blueprint which the European Central Bank is using for its own “rescue”:

1) Invoke emergency measures and do the opposite of what a central bank is supposed to do: create great big of gobs of money and throw the largesse around wherever you like. The obsolete term for this is “cranking up the printing press”, but this goes far beyond any printing press capabilities, as physically printing the hundreds of billions of euros or dollars at the speed with which they are being created would likely melt down a press.

2) Take those vast sums of money, and use them to entirely bail the banks and bankers out of their bad investments. There’s no budget, no legislative hearings and no formal rescues or bailouts to be debated or repaid. Just pay the banks more than the market says the investments are worth, and let the bonuses continue to flow!

3) The catch is that the new money can’t actually be spent, or the public might catch on to what’s happening when the cost of bread goes through the roof. Being the ungrateful sort, however, the banks are exactly the type who would take their rescue money and go spend it if there was more money to be made that way. So unlimited money is made available to bribe the banks, and keep the banks’ money safely inside the corral (i.e. “sterilized”).

4) The more money the banks get, the less real economic investment assets they have, and the bigger the portion of their assets that consist of nothing more than the monetary creation ability of the central banks.

5) Meanwhile, the fundamental problems that led to the crisis in the first place are still there, and the pain of dealing with them has been deferred into the future. At which time, they are likely to blow up worse than ever because delaying action never does help these things – but the focus of these emergency actions are about today. Tomorrow can take care of itself.

6) If you are a banker or politician, and if the fundamental problems do blow up much worse down the road – so what? The end result is the same, but you’ve kept what you think is one of the best jobs in the world in the meantime.

7) On the other hand, if you are a member of the general public, and if there had been no rescue packages, then there would have been a terrible price today, but at least you would have had your savings to fall back on. Thanks to the brilliance of central bankers and rescue packages however, this way when things do blow up, the economic damage is worse than ever, job losses are bigger than ever, and the value of your savings and retirement accounts just went “poof”, too.

8) Good thing the general public has no idea what these economists are really doing, eh? (And the public never will know, unless articles like this are circulated more widely… if you find this outrageous, tell as many people as you can about it.)

The Choice Between Opportunity & Being Victimized

The heart of the current battle is a series of frantic measures being taken by desperate people who are in way in over their heads and are trying to preserve their own privileged way of life. Their collective greed and short-sighted pursuit of personal bonuses got us all into this mess. They don’t know the way out. But they are determined to use their full power to try and save themselves, and that includes changing the very nature of money itself. It is a high risk attempt, and the risk involves everything you, I and our families have worked for and built over our lifetimes. A relatively tiny group of people taking massive risks for all of us in the attempt to save themselves – is nothing more than human nature. The decision is particularly easy when the people in question have spent their careers in the steadfast accumulation of personal wealth and power.

As is usually the case, there is also a silver lining, slim though it may be for society as whole. When desperate people rush into changing the world, changing the rules, and creating artificial trillion dollar markets, they also do something else. They leave a multitude of doors open. All over the world through multiple asset (and liability) categories, doors are being inadvertently left wide open for unparalleled personal arbitrage opportunities. The open doors are inadvertent because there is no master strategy, and nobody’s had a chance to think through all the implications.

The financial heads of Europe were up until 3:15 in the morning, and they were desperate, so they did a “shock and awe” on the long-term value of their nation’s own collective currency in their efforts to convince the banks that there was no chance of banks taking a loss on bad investments in the short term. It is inevitable that with such radical and comprehensive change – extraordinary but temporary opportunities opened up for investors, that would not be there in a stable monetary and financial system.

Fundamental opportunities are opening up in multiple ways for creating wealth. For highly risk-averse investors, this may involve protecting what you have on an after-tax and after inflation basis, and maybe even modestly growing it a little. (Which is saying a lot for these times.) For those who understand risk and don't mind taking it for the right reasons -- there are speculative opportunities to create multi-generational wealth.

To find those open doors requires doing something fundamental, which can be quite uncomfortable for many people. It starts with accepting that the times truly have changed and are continuing to change.

What happened in Brussels over the weekend was that the nature of money changed. The nature of the euro changed, as the nature of the US dollar has fundamentally changed, as have many other currencies over the last couple of years. This in combination with radical, trillion dollar government market interventions has also fundamentally changed the very nature of the investment markets. The paradigm has changed, and everything most of us have is at risk because of this. The paradigms that governed successful investment – and the preservation of capital in the 1990s and the 2000s – are now obsolete.

Those who follow obsolete paradigms become victims. Those who understand the new paradigms find extraordinary opportunities, until such time as the new paradigm becomes widely understood and accepted. The difference between victim status and seizing the opportunity is quite simply one of learning and education. If you're going to build investment capital in these bizarre and terrifying times – what you need before anything else is intellectual capital.

I realize that for many people, reading fundamental articles that explain central bank actions and investor implications is about as appealing as dental surgery. For the sake of what you have built, and for your future – let me urge you to read (or re-read) the linked articles. I have done my best to make them as understandable as I could, and have received letters from around the world from people telling me that for the first time they are truly understanding what is happening. Consider taking the time to learn what you need to know.

Seek education. Seek learning. Read widely. Good luck to you in these perilous times.

Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, thiscourse delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com .

Contact Information:

Daniel R. Amerman, CFA

Website: http://danielamerman.com/

E-mail: mail@the-great-retirement-experiment.com

This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.

Copyright 2010 by Daniel Amerman