Trumped! A Nation on the Brink of Ruin... And How to Bring It Back

by David Stockman

  As to the former, France’s banking system is the granddaddy of corpulence. Total assets in the system amount to $9.5 trillion—a figure that is nearly 4X its $2.4 trillion GDP. Likewise, Italy’s banking assets total $4.3 trillion, or 2.4X its $1.8 trillion GDP.

  In both cases these banking-to-GDP ratios are off the charts. They reflect not only highly leveraged domestic economies, but also massive external lending to sectors like global shipping and energy that are now being hammered by vast excess capacity, plunging cash flows and rising defaults.

  That’s their Achilles heel. In the case of Italy, for example, there are now about $2.6 trillion of loans in its banking system, and upward of 17% are nonperforming. In relative terms, that is nearly 4X the bad-debt ratio that prevailed in the U.S. banking system at the peak of the subprime crisis.

  Needless to say, these $440 billion of nonperforming loans are growing rapidly, but are not even close to being fully reserved. In fact, Monte Paschi, Unicredit and three other big Italian banks have $130 billion of nonperforming loans that are unprovisioned. That compares to total book equity of just $138 billion in Italy’s entire banking system at the end of Q1 2016, meaning that Italian banks are essentially insolvent.

  The French banks are only slightly less impaired. But given the combined $14 trillion balance sheet of the French and Italian banks, one thing is quite certain. To wit, when their banking systems go into an accelerating meltdown, France and Italy will end up in a bruising conflict with Berlin and a fractured EU governance process in Brussels.

  This potential fracture has already erupted over the EU’s brand-new rules requiring a “bail-in” of depositors and bondholders. The latter requires that the depositors and bondholders would take huge losses before tax funds could be injected into domestic banking systems. Italian Prime Minister Renzi has already noisily demanded that these rules be suspended, as has the CEO of France’s second-largest bank.

  The plain fact is that the imposition of bail-ins in either country would cause a massive depositor run and a crushing sell-off among bondholders. In addition to trillions of deposits, the three largest French banks—BNP Paribas, Société Générale and Crédit Agricole Group—also have issued $1.1 trillion of bonds and other long-term liabilities, while the Italian banks have upward of $300 billion of bonds outstanding.

  Furthermore, in yield-starved Europe these bank bonds are widely held by retail investors. This means that a bail-in would generate massive losses and voter insurrections, and cause the near-instantaneous fall of their left-of-center and socialist governments.

  On the other hand, absent a bail-in the EU doesn’t remotely have the resources to recapitalize these monster banks. Nor does Germany have the political will or financial capacity to any longer foot the lion’s share of the bill.

  That gets to the true problem. In the absence of EU intervention, neither France nor Italy have the fiscal capacity to prop up their own banking systems because they are essentially tapped out.

  Thus, France’s public debt has been relentlessly rising, and is up by nearly 50% just in the last nine years. It now amounts to 85% of GDP, and would rapidly cross the 100% threshold in the context of a recession and a major bank-bailout program.

  And that’s not the half of it. Nearly 50% of France’s $2.4 trillion of public debt was recently trading at subzero yields.

  That’s right. The bond markets have been so deformed by the European Central Bank, the Fed and other central banks that a socialist dead-ender government like that of French President Hollande is being presently paid to borrow money!

  There is a word for that: lunacy.

  But the operative word for our purposes is “presently.” In truth, subzero rates are an unsustainable momentary aberration. Were the EU to splinter and France be required to prop up its own banks, yields on its debt would soar, widening its fiscal gap even further.

  The fact is, France is a socialist basket case. The state has been steadily and surely devouring the entire private economy.

  Consequently, the government sector is now pushing 57% of GDP, and it has not stopped climbing toward the upper right of the graph for nearly four decades. Indeed, it is virtually inconceivable that the relentless expansion of the French state shown below can ever be stopped by democratic means—or any other, for that matter.

  The baleful implication is that France’s oppressive level of taxation on virtually everything—incomes, labor, consumption, luxuries, capital—has virtually no chance of being eased without triggering an immediate eruption of deficits and public debt.

  At the same time, France’s massive tax burden—which now amounts to 52% of GDP—has kept its economy pinned close to a flat line ever since its modest postcrisis rebound. Total real GDP today is only 4% higher than it was in 2008, and as often as not quarterly GDP has been negative.

  Likewise, notwithstanding a 1.4% average inflation rate since 2008, the nominal value of gross capital formation still has not recovered to 2008 levels, nor has manufacturing production.

  This means that in real terms the industrial core of the French economy has been shrinking. GDP has crawled forward at 0.4% per year since the precrisis peak only because prodigious government borrowing allowed the state to fund sufficient transfer-payment spending and direct public-sector purchases to make up for the industrial shortfall.

  In fact, as shown in the graph below, French industrial production in physical or real terms is actually 17% below its precrisis peak, and below turn-of-the-century levels by nearly that much.

  Accordingly, we believe the French economy is going down for the count. In the face of a shrinking industrial core owing to oppressive taxation, monopolistic union wages and huge welfare-state inducements for idleness, there is no reason why that it can continue to borrow its way to even the tepid growth of the recent past.

  This means, in turn, the growth of its public debt will continue to outpace a stagnant or even shrinking nominal GDP, thereby pushing its public-debt ratio ever higher. Under those circumstances, therefore, there is not a chance in the world that it can bail out its monumental $9.5 trillion banking sector, or that its $1.2 trillion of subzero public debt can avoid a thundering collapse.

  Nor is the eventual collapse of France’s sovereign-bond and banking bubbles necessarily a matter for the distant by-and-by.

  The populist candidate Marine Le Pen is already well in the lead for France’s 2017 presidential election. Brexit has now given dramatic new impetus and credibility to her anti-EU platform.

  Even the possibility of a Frexit win next year would trigger a relentless wave of selling by the Draghi front-runners who are now buying the 10-year bonds of this terminally ill state at a mere 20-basis-point yield.

  In theory, of course, the clueless Draghi is pegging French bond rates in the subzero zone in order to jump-start inflation. In practice, he is setting up a monumental financial explosive device that could erupt at any moment owing to Frexit risk, European recession, EU break-up, a German revolt at the European Central Bank or numerous other potential catalysts.

  WHY THE EU SUPERSTATE WILL FAIL—THE ITALIAN JOB

  Needless to say, the banking collapse and fiscal breakdown in Italy is even more severe than that of France. That’s in part because the capital deficit in Italy’s banking system is bigger, but also because Italy’s towering public debt is far greater in proportionate terms at 133% of GDP.

  So the notion that recent yields of 1.20% on the Italian 10-year bond even remotely compensate for the risk embedded in Italy’s fiscal and economic chamber of horrors is just plain laughable. And that’s to say nothing of the risk that the EU itself will ultimately succumb to a wave of populist insurgency, including a Five Star Movement–led move to take Italy out of the euro.

  There is probably no better gauge of Mario Draghi’s “whatever it takes” folly than the massive rally that subsequently occurred in the 10-year bond of his home country. The Italian economy improved not one whit after 2012, and its fiscal rat
ios continued to worsen.

  So the 500% gain in the value of its benchmark bond was entirely due to traders front-running the European Central Bank’s announced bond-market interventions and purchases. Never before has an arm of government showered such insensible windfalls on speculators—who, more often than not, funded their positions with repo loans, which, also thanks to the European Central Bank, were essentially costless and risk free.

  Indeed, Italy is truly a case of the blind leading the blind. As indicated above, its giant, bloated banking system is essentially insolvent with $440 billion in nonperforming loans, but on top of that it also holds $300 billion of Italian sovereign debt.

  Italy’s languishing economy would be toast, in fact, if its banks were not propped up by the state. Real GDP is still 8% below its 2008 level—and that’s with loans from Italy’s massive $4.3 trillion banking system embedded in every nook and cranny of its state-managed economy, and with a further boost from state transfer payments and direct spending financed, on the margin, by government borrowing.

  Yet an Italian state bailout of its own banking system is a circular proposition; it has been the banking system that has brought a growing share of new government-debt issues.

  Needless to say, these government-debt securities are vastly overvalued owing to the Draghi bond-buying spree. They would instantly plummet in price were the speculators who have been front-running Draghi’s QE campaign ever to lose confidence in the European Central Bank or the ability and willingness of an Italian government to continue the giant fiscal charade now in place.

  In short, a normalization of rates would cause the interest carry cost on Italy’s giant government debt to soar by 3X or even more. Indeed, the combination of Italy’s massive public debt, state-strangled economy and shrinking labor force amount to a doomsday machine in every sense of the word.

  As it happens, this implicit existential challenge is materializing right now. The Renzi government has been desperately attempting to organize a bank bailout, but has run smack into the trauma-inducing bail-in rules described above.

  That EU banking framework, of course, would not only would mean massive losses for depositors and bank debt-holders, but also the instant collapse of the Renzi government.

  Accordingly, Renzi has ceaselessly attempted to get a waiver of the new rules on the grounds that the Italian banking crisis has been dramatically intensified by the Brexit shock.

  Yet German resistance is rooted in a powerfully self-evident reason—namely, that the bail-in rules are designed to prevent new fiscal crises in member states and the need for more German-funded bailouts.

  So now Italy faces the real possibility of a depositor run on its banks, and a devastating liquidity crisis in its $4.3 trillion banking sector.

  Accordingly, either the EU must open up the floodgates to a renewed round of bailouts, which would likely result in the collapse of Merkel’s government, or it must authorize Italy to spend upward of $50 billion to recapitalize its banks and keep the $300 billion of government debt they hold safely in their vaults.

  Then again, with public debt already at 133% of GDP, why would anyone except Mario Draghi, with his printing press, be buying 10-year Italian bonds at a 1.20% yield?

  Stated differently, once the European Central Bank stops monetizing its debt, it’s curtain time for the Italian debt market, banking system and economy. But if it doesn’t stop, the perpetuation of negative interest rates will take down the entire European financial system.

  There is really no way out of the Italian Job. The industrial core of Italy’s economy is a far-worse basket case than even that of France. As shown in the next chart, industrial production is now 25% smaller than it was at the precrisis peak and also the year 2000.

  Stated differently, so far during the 21st century Italy’s industrial economy has shrunk by one-quarter, and each modest attempt at recovery has rolled over. The gains after 2005 were lost to the Great Recession. The rebound from the latter was lost to the Eurozone financial crisis of 2011–12, and all of Mario Draghi’s bond-buying madness has not been able to generate any lift at all during the last three years.

  So the question recurs. How does a deteriorating economy support enough government borrowing to keep a giant insolvent banking system going, pay the interest on an already-monumental public debt and then borrow even more to inject Keynesian-style “stimulus” into a moribund private sector?

  It can’t. That’s why the Italian Job will sooner or later take down the EU superstate.

  WHY THE BREXIT REVOLT WILL SPREAD

  The combustible material for more referenda and defections from the EU is certainly available in surging populist parties of both the left and the right throughout the Continent.

  In fact, another hammer blow to the Brussels/German dictatorship will surely happen in Spain, and probably before the end of 2016. That’s because the corrupt, hypocritical, lapdog government of Prime Minister Rajoy is surely on its last legs, and properly so.

  Rajoy is just another statist in conservative garb who reformed nothing, left the Spanish economy buried in debt and gave false witness to the notion that the Brussels bureaucrats are the saviors of Europe.

  So despite still another election this year after the December 2015 elections resulted in paralysis, Spain still has no government, and Catalonia is still on a determined path to secession.

  The anti-Brussels parties of both the left (Podemos) and the right (Ciudadanos) represent aroused constituencies that simply have had enough of the status quo and rule from Brussels. So not withstanding short-term parliamentary maneuvering, Spanish politics will remain splintered and paralyzed.

  And that’s the problem when the inexorable Eurozone financial crisis intensifies. There will emerge no government in Madrid strong enough or willing enough to execute Brussels’ inevitable dictates in the event that the drastically overvalued Spanish bond market goes into a tailspin and requires another EU intervention.

  So the next leg of the Brexit storm is foreordained. To wit, sovereign-bond prices throughout Europe have been lifted artificially skyward by the financial snake charmers of Brussels and the European Central Bank.

  The massive rally in Spain’s 10-year bond after Draghi’s “whatever it takes” ukase was not due to Spain becoming more creditworthy or because its economy has come roaring back to life. In fact, industrial production in mid-2016 was 7% below the level it attained prior to Draghi’s 2012 ukase, and 25% below its 2007 peak.

  Indeed, Spain’s industrial economy actually remains 19% smaller than it was at the turn of the century, before its euro-based domestic-borrowing and construction spree got underway. Likewise, its unemployment rate has dropped from 26% to 20%, but that’s still more than double pre-boom levels.

  The whole plunge of yields from 7% to a low of 1% in mid-2016 was due to the front-runners’ stampede we described earlier. That is, the fast-money crowd was buying on repo what the European Central Bank promised to take off their hands at ever-higher prices in due course. They were shooting the proverbial ducks in a barrel.

  But as global “risk-off” gathers worldwide momentum, look out below. There will be no incremental bid from Frankfurt for a flood of carry-trade unwinds that will hit the sovereign-debt market. That’s because the European Central Bank will soon be embroiled in an existential crisis as the centrifugal forces unleashed by Brexit tear apart the fragile consensus on which Draghi’s lunatic monetary experiments have depended.

  In particular, the populist political insurgencies throughout Europe are as much anti-German as they are anti-immigrant. It is only a matter of time before Germany’s acquiescence in the European Central Bank’s massive bond-buying campaign—which essentially bails out the rest of Europe—will be abruptly ended by an internal political revolt against Merkel’s accommodationist policies.

  Moreover, the ongoing anti-EU upheaval in Spain is by no means unique. Italy’s Five Star Movement, which just came from winning 9 out of 10 mayoral contests
including Rome, will surely now be energized mightily. Its Northern League ally has already called for a referendum on exiting the euro.

  Indeed, the prospect of anti-establishment revolts throughout the EU—including growing demands for a Dutch referendum—have drastically turned the tables. That is, during the great financial crisis our elite rulers cried financial “contagion.”

  That scary story generated panic among the politicians and acquiescence in the financial elites’ crooked regime of massive bailouts and relentless money pumping. The effect of it was to bail out the gamblers from the Greenspan/Bernanke housing and credit bubble, and then to shower unspeakable windfalls on the 1% as the central banks reflated an even-more-monumental bubble during the regime of QE, ZIRP and NIRP.

  But now the world’s financial rulers are going to be on the receiving end of an even-more-virulent and far-reaching political “contagion”—that is, a tidal wave of voter demands to emulate the British people and take back their countries and their governments from the financial elites and politicians like David Cameron, Mariano Rajoy and Matteo Renzi who are their bagmen.

  This time populist and insurgent politicians are not going to roll over for the rule of unelected central bankers and the international financial apparatchiks of the IMF and related institutions.

  In that context, it can be confidently said that the Eurozone and European Central Bank are finished. That’s because the monstrously inflated euro-bond market that Draghi created will implode if the front-running speculators lose confidence in the scheme or the European Central Bank emits even a smidgeon of doubt about its ability to run the printing press at $90 billion per month indefinitely, world without end.

  At length, it will become evident that Draghi’s “whatever it takes” gambit was the single most foolish act in the history of central banking. It assumed that the rule of the financial elite was limitless and endless.