The world’s ‘Economy of Stupid’ is breaking down, the decline manifests itself where the attention of central bankers is distracted. Now, comes a nascent money panic in Southern Europe:

Fears of ‘Lehman-style’ tsunami as crisis hits Spain and Portugal

By Ambrose Evans-Pritchard

The Greek debt crisis has spread to Spain and Portugal in a dangerous escalation as global markets test whether Europe is willing to shore up monetary union with muscle rather than mere words

Julian Callow from Barclays Capital said the EU may to need to invoke emergency treaty powers under Article 122 to halt the contagion, issuing an EU guarantee for Greek debt. “If not contained, this could result in a `Lehman-style’ tsunami spreading across much of the EU.”

Credit default swaps (CDS) measuring bankruptcy risk on Portuguese debt surged 28 basis points on Thursday to a record 222 on reports that Jose Socrates was about to resign as prime minister after failing to secure enough votes in parliament to carry out austerity measures.

Parliament minister Jorge Lacao said the political dispute has raised fears that the country is no longer governable. “What is at stake is the credibility of the Portuguese state,” he said. 

Portugal has been in political crisis since the Maoist-Trotskyist Bloco won 10pc of the vote last year. This is rapidly turning into a market crisis as well as investors digest a revised budget deficit of 9.3pc of GDP for 2009, much higher than thought. A €500m debt auction failed on Wednesday. The yield spread on 10-year Portuguese bonds has risen to 155 basis points over German bunds.

Daniel Gross from the Centre for European Policy Studies said Portgual and Greece need to cut consumption by 10pc to clean house, but such draconian measures risk street protests. “This is what is making the markets so nervous,” he said.

In Spain, default insurance surged 16 basis points after Nobel economist Paul Krugman said that “the biggest trouble spot isn’t Greece, it’s Spain”. He blamed EMU’s one-size-fits-all monetary system, which has left the country with no defence against an adverse shock. The Madrid’s IBEX index fell 6pc.

The sinking ‘Subprime’ states; Portugal, Italy, Greece and Spain leaving behind the usual damsels in distress. Callow emits the by- now obligatory hostage demand: ‘bail us (Barklays?) out or else!’ This is the saber- rattling pas de deux. The bailout is inevitable, but no one will act until there are bodies in the streets and anguish in the stock markets. This is to provide cover for the politicians.

While all tis theater is taking place, the rhetoric intensifies against ‘bulging’ US government debt, as if the USA is on the same slippery slope as Greece. Says James Galbraith (in an excellent interview:

First of all, it’s very clear that the United States government is not constrained externally, and it’s clear that quite apart from the stimulus package, the automatic stabilizers and the financial rescue, which greatly ballooned the public debt of the United States, have had no effect on the ability of the United States government to fund itself and no effect on the interest rates that the government pays. So, it, I think, follows from that logically and straight-forwardly that we have nothing to fear from additional efforts as long as they are necessary. And they’re obviously very clearly necessary. So the question is: what should be the structure of those efforts?

Also Paul Krugman:

To me — and I’m not alone in this — the sudden outbreak of deficit hysteria brings back memories of the groupthink that took hold during the run-up to the Iraq war. Now, as then, dubious allegations, not backed by hard evidence, are being reported as if they have been established beyond a shadow of a doubt. Now, as then, much of the political and media establishments have bought into the notion that we must take drastic action quickly, even though there hasn’t been any new information to justify this sudden urgency. Now, as then, those who challenge the prevailing narrative, no matter how strong their case and no matter how solid their background, are being marginalized.

And fear-mongering on the deficit may end up doing as much harm as the fear-mongering on weapons of mass destruction.

Let’s talk for a moment about budget reality. Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

The point is that running big deficits in the face of the worst economic slump since the 1930s is actually the right thing to do. If anything, deficits should be bigger than they are because the government should be doing more than it is to create jobs.

Sometimes the ne0- classical economists are right! While both do not examine the mechanics of sovereign borrowing, the central fact is that the US government borrows in its own currency. There is no limit to the number of dollars the US can create, either by borrowing from the Federal Reserve or by simply ordering the Treasury to emit them, as did ‘Honest’ Abe Lincoln during the US Civil War.

The ‘Deficit’ is an artifact of double- entry bookkeeping. The creation of any amount of debt simultaneously creates the funds required to pay it. The creation of funds effects the market for the debt – the more debt that is created, the lower the interest cost is to service it. Consider Japan which has borrowed for decades up to 300% of GDP …  at less than 2% for 10 year bonds. The existential nature of the debt – plus its funding – isn’t the issue. These funds when put into service in the economy are supposed to multiply themselves by the magic of fractional reserve lending. A problem with the inflating government spending is that currently there is no multiplying taking place. The deficit is a wasted effort!

In most places in the developed world, where the sovereign borrows in its own currency, the service cost is near zero. The cost of running a deficit is very low.

The issue of borrowing in one’s own currency founders on other issues; the inability to ‘print’ jobs or to ‘print’ crude oil and the multiplication of redundant claims which cost a government (or governments) credibility. 

A $600 trillion- gazillion- bazillion deficit is not rational policy. That derivatives and unfunded liabilities are measured in the hundreds of trillions is absurd. There isn’t the resources available to meet these claims.

The current danger is where a sovereign must borrow in a currency other than its own as is the case in Europe. Greece, Spain and Portugal are borrowing in a ‘foreign’ currency, the euro. Since none of these countries can print euros, the only way these governments can find funds to pay operating expenses – or to service new debt to retire old debt – is to ‘rent’ euros from ‘foreign’ investors, at increasingly high interest rates. 

Interest rate increases form a positive feedback loop where the fact of the increase amplifies the rate. The implication grows of impaired creditworthiness and accelerated future borrowing difficulties which become self- fulfilling. The Greeks cannot convince investors to lend to them @ 7% so they try 8%, then 9% then 10%. This is the compounding debt spiral which is what is facing the euro borrowers.  The process itself creates insolvency as ‘production’ is diverted into hopeless finance. Without outside funds – a lender of last resort – there are runs on the institutions and the economy grinds to a halt for lack of funds.

Since these nations cannot borrow in their own currencies, their borrowing costs are subject to arbitrage – between borrowing costs in one country versus another using the same currency. While this is taking place, the distressed countries cannot devalue euros. The ECB and EMU demands bake austerity int0 the common currency cake! The more expensive euros amplify deflation. Right now, there is no way out for the so- called ‘Club Med’ countries. As Ambrose Evans- Pritchard suggests, the subprime sovereigns need an ‘American- style’ bailout – or, grants. Failing that, a low- cost lender of last resort. 

Providing currency equilibrium and a sovereign lender of last resort was supposedly a benefit of euro membership …

Unfortunatelyt, bailouts … simply borrow some time. The underlying conditions that precipitated this crisis have not been addressed. The citizens of the developed world are living beyond all means. Like children, we cannot say no. We are having an energy crisis,l not a liquidity or even a credit crisis. The defects in lending and debt service are symptoms, not the disease! Says Galbraith:

I’ve always taken exception to the constant reference to “stimulus” as the policy objective, because implied in that word is the idea that all one needs to do is to undertake one or more relatively short term spending sprees, on whatever happens to be available at the moment, and that this will somehow return the economy to its pre-crisis state, putting it on a path of what economists like to call “self-sustaining growth.” I maintain that in the present environment there is no such thing as a return to self-sustaining growth. There will be no return to the supposedly normal conditions, which were in fact, from a historical point of view, highly abnormal, of the 1990s and 2000s.

What one needs is to set a strategic direction for renewal of economic activity. We need to create the institutions that will support that direction. Those institutions are public institutions, which create a framework for private activity. This is the way it is done. It is the way countries have always developed in the past and, to the extent that they are successful, they will always do so in the future or they won’t succeed. Seventy years ago when we were in the Great Depression, they built a national infrastructure: roads, airfields, schools, power-grids – this kind of thing was the priority. In the post-war period, the creation and maintenance of a large middle class with social security, with medical care, with housing programs, universities – these were the priorities of the post-war period.

Energy conservation is a great way to start. There is no other way to bring the current worldwide crisis under control. So far, trillions of dollars, Pounds, yuan, euros and whatever else have been thrown into the furnace. The crisis is continuing, eroding commerce from the bottom up. At some point the bailouts will cease, either because the means to continue them are exhausted or because someone finally recognizes their futility.

It’s the energy, stupid!