The Flight of the Wedding Cake

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“Few people can hate so bitterly and self-righteously as the members of a ruling caste which is being dispossessed.” TH White, The Once and Future King

You’d never guess Europe is approaching financial reckoning day if you were using the Aussie share market as a trip wire. The Aussie market is melting up this morning. Perhaps this is in anticipation of a ripping earnings season from the large number of corporations that report results this week.

Or, perhaps, it is ignorance of how Europe’s crisis affects Australia. And after all, ignorance can be forgiven. It is a lack of knowledge. And there’s a lot we don’t know about Europe.

For example, if investors in Greek government bonds face a 60% loss on their bonds instead of a 20% loss, what will that do to them? Those investors are European banks. And those banks are the banks that already need some €108 billion in new capital by the end of next year. Won’t they need more if their Greek losses are larger?

Stop!

Before we go any further into the details we should highlight the big problem: everything affects everything. If you make a “grand plan” to recapitalise the banks and prepare for the next crisis, but your plan depends on Greek bond losses being fixed…well, your plan is screwed.

This is why the Europeans are doing a lot of talking but not much else. The latest news is that everything will be revealed on Wednesday. The Greek write offs, the bank recapitalisation plan, the funding of the bailout mechanism, which is meant to restore confidence in Italy and Spain and prevent borrowing costs from rising there…all of that should be ready by, let’s say, Wednesday.

There is a problem in all this that we are trying to get at. We spent most of the weekend thinking it over. The problem is not economic or financial. It is philosophical.

At one level the problem is easy to understand: too much financial complexity. We’d argue this is a result of a monetary system in which money is not a real thing (a commodity) but an idea. When money isn’t a real, tangible thing, it makes the creation of complex, fantastical financial models possible.

For example, the Europeans are looking for ways to “leverage” the size of $529 billion European Financial Stability Facility (EFSF). By “leveraging” it they can make it larger than it appears, which gives the illusion that the fund can do more work. One example is to use the fund to insure holders of Italian and Spanish bonds against losses.

But you can see the problem here. Using the fund to insure bondholders against losses is designed to restore confidence in Italian and Spanish debt. Assuming the Italians and the Spaniards can get their government deficits under control…well then everything will be fine, won’t it? The crisis will pass. Growth will resume. Nothing bad has to happen.

Mind you, Italy has $2.57 trillion in government debt. That’s 120% of Italian GDP. It’s the third-largest economy in Europe. If tiny little Greece can nearly bring Europe undone, what about big bad Italy? This is what the 27 members of the European Union fear, and the 17 users of the common currency…a complete breakdown of their artificial monetary union.

“Leveraging up” the EFSF amounts to making it look bigger than it actually is. A simpler way of saying this is that the Europeans don’t have enough money to pay off their collective debts. Their solution is to make a small amount of money punch above its weight. This isn’t going to work.

These complex financial schemes are the Crystal Palaces of the Financial Age. But of course, they are pure accounting fictions. Not real things.

The Crystal Palace was a steel and glass monument to the Industrial Revolution. It was the physical embodiment of an idea. The EFSF, by comparison, is a disembodied idea. It is an abstraction. It is the idea that increased leverage can disguise real insolvency.

But if we were to describe it as a real thing – in fact if we were to describe Europe’s predicament as a real thing – we would describe it as a magnificent 17-storey wedding cake that’s been dropped from a very tall building.

A camera zooming in on the details of the cake would show you layer after layer of solid, delicious-looking cake. You’d see the delicate icing, the 17 happy brides and grooms on top, saying their vows at the altar of centralisation. You’d see little roses and fluers de lis and beautiful embellishments of incredible complexity and finery.

But all the while, the cake would be falling toward the ground at 9.7536 metres per second, per second. No amount of refinement would delay the inevitable work of gravity. Yet if your vision were focused too narrowly on the cake itself, you would not notice the arc of its flight. Or that its flight was really a plunge.

This is why we continue to remind Australian investors about what’s happening in Europe. The cake is falling. We may be ignorant of what happens when it lands. But for goodness sake, don’t stand under it!
And you may want to be clear of the splat zone altogether, although here the metaphor breaks down. To be splattered with cake doesn’t seem that bad compared to owning a portfolio of crashing financial stocks. Still, beware the cake shrapnel and possible collateral frosting.

What is the philosophical problem with all this? The Europeans have made a crucial mistake about human nature. The idea behind their common currency was flawed from the beginning because their idea about man was wrong. More on this error tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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5 Comments on "The Flight of the Wedding Cake"

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plaasmatron
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It wouldn’t be falling toward the ground at 9.8ms-2. It would be accelerating toward the ground at 9.8ms-2. Its speed would depend on how long it has been falling and any resistance.

I guess that’s why you studied finance and not physics. In the first if you make a mistake, you crash a $Trillion economy, which doesn’t matter. In the second if you make a mistake, you crash the $327m mars climate orbiter, which doesn’t matter either I suppose.

Keep thinking, keep writing.

Pete
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Let’s not let the finer details of a metaphor ruin a good article plaasmatron

SvetlanaBabe
Guest
The assumptions on human behaviour that are inherent in a lot of economic thought are more often than not completely absurd. For example, consumers buy the same basket of goods the ABS uses in it’smeasurement of CPI, regardless of price is one of those absurd assumptions. It assumes people will not look for bargains or substitutions. There are many more absurdities, like assuming that all actors in society all act in their own self interest all the time. Economics will never be a science and far from an exact science! II would contend as with everything else, realising humans are… Read more »
Annon
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That’s why he said per second per second… keep reading and not writing.

“It wouldn’t be falling toward the ground at 9.8ms-2. It would be accelerating toward the ground at 9.8ms-2. Its speed would depend on how long it has been falling and any resistance.”

shortchanged
Guest

My early last century schooling taught me that, falling objects achieve a maximum velocity, of 32 feet per second per second. Irrespective of Weight or size, however, since scientists seems to change their minds like politicians on a campaign trail the argument is, “mute”.( used as an adjective )

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