European Equities: Flames on the Horizon

28th April 2022 Kevin George

It seems people have finally woken up: inflation has hit with a bang, and isn't going anywhere for some time to come. There's plenty of fuel from which the inferno is drawing, much of it hot on everybody's lips: the conflict in Ukraine, US- and Euro-led sanctions against Russia, Russia's counterplay to break away from the previously globally enforced petrodollar – all following the tumult of the past two years about which we need not say more.

However, a call to the financial fire brigade – or, as they would have you believe, the central banks – is utterly forlorn.

If we're taking an honest look at the reasons behind the pandemonium of today, we ought to consider the inevitable outcomes of widespread use of fiat money: currency backed by no tangible, concrete or redeemable underlying asset, and instead supported by the “full faith and credit” of its issuers.

Indeed, regardless of hostile military excursions in Eastern Europe or two years of Covid communism, the dire straits of today are the result of more than fifty years of unbridled money printing by central banks, their direct purchasing of treasury bonds and suppression of interest rates all the way into the minuses. And, the Eurozone in particular is on the verge of being set ablaze.

Just as the US Federal Reserve, the Bank of England and the Bank of Japan have done, the European Central Bank (ECB) has sunk interest rates all the way to zero (lest we forget that real rates are underwater, owing to inflation) and indulged itself with Quantitative Easing (QE as many of you will have heard). That is to say, each central bank finances its respective government's spending by purchasing that government's treasury bonds with currency created from thin air, which in turn flows out into the wider economy, with the government and its cronies acting as an early-stage filter. To illustrate the scale to which this has been done, the combined balance sheet of the ECB, the Fed, BoJ and the People's Bank of China now stands (as of the end of 2021) at $31 trillion, with little sign of the watering-down of their currencies abating in the foreseeable future.

For you and me, this is essentially why we see astronomical price increases for our everyday goods and services; the more you expand the quantity of currency units, the less one can purchase with that currency (assuming all other things are held constant). Hence, it isn't just consumer goods and staples whose prices are blasting off: a raft of base-level commodities (lumber, oil, gas, nickel to name but a few) have typically doubled in the space of the past year or so, leading to even larger increases in the Producer Prices Index (PPI), thus pouring rocket fuel on the inflationary flames.

Of course, the price of specific commodities (e.g. wheat) is also affected by, not least, Russia's incursion into Ukraine and, more specifically, the sanctions levelled against Russia by the West in retaliation. Ultimately though, it would be blatantly wrong to lay the blame for the current economic carnage at the feet of Russia. Just as easily, as far as oil and gas may be concerned, could one point to Joe Biden's decision to cancel the Keystone pipeline, thereby restricting the supply of energy from Canada into the USA, or his anti-fracking approach which he has bullishly implemented since taking his seat in the Oval Office.

Simply put, with a one-two of choking off pipelines on one side of the Atlantic and trying to prohibit exports from the planet's second-largest hydrocarbon producer on the other, is it any wonder why prices of crude oil and natural gas have broken through the exosphere of late?

The consequences will affect us all: a fiery mass large enough to engulf the globe which we've only just begun to feel. But, why do we identify Europe, in particular the Eurozone, as a cause for concern?

At the behest of the establishment in Washington, NATO has decided to escalate economic warfare against Russia – and by extension much of the rest of the world, who remain largely neutral in the ongoing conflict in Ukraine, continuing to trade with Russia as befits their interests. It follows that many NATO members are Eurozone members, too. The effects of banning the purchase of Russian gas for a country such as Germany, say, would be disastrous, not least because the Eurozone's largest industrial base would be shut down in a matter of days. It is expected that Germany will cave in to Russia's demands, “Roubles or gold for oil and gas”, such is the awareness of the Regierung of their current conundrum.

Nevertheless, the Eurozone and its members face a uniquely ominous collapse, thanks largely to its underlying structure. Consulting the incredible insight of Alasdair MacLeod: whilst the ECB has trodden the same path as its counterparts in the UK, USA and Japan, it is a central bank which does not answer to one national government. The underlying national central banks have dual mandates, first to the ECB and then their subordinate national governments. These national central banks each hold shares, to varying degrees, in the ECB.

With its liabilities now greater than the underlying shareholder equity, the ECB is essentially insolvent, a position which also befalls the Bank of England and the Bank of Japan. Now, whereas in the UK, for example, the Bank of England could ask Westminster to cover any shortfall in its accounts, or indeed take on more equity in the Bank (through recapitalisation of the Bank itself), this route is closed off to the ECB, as each underlying national central bank is effectively a shareholder of the ECB.

MacLeod's work is diligently detailed and expertly explained, to the point where our summarisation would be woefully inadequate. It's best therefore for you to afford the time to read the above article in full, but MacLeod does put it more succinctly here, though:

“The financial structure of the Eurozone, the sharply different economic and political interests of the member states, together with the legacy of bad debt coverups over a string of financial crises and compromises since its inception all point to a lack of any desire to resolve the ECB’s insolvency. Only by individual governments standing behind their own national central banks can they be recapitalised, conditional on the ending of the euro system. No longer can Germany subsidise Italy, Spain and France. A recapitalised Bundesbank will have to walk away from its ECB capital key, as must all the other national central banks. And the Bundesbank will have its hands full stabilising its own commercial banking network.”

Strangled energy supply, central-bank insolvency and rampant inflation might well be the Cerberus sent forth from Hades to incinerate the Eurozone. The ashes will indeed scatter not just the continent, but most likely the entire globe, given how intricately linked today's financial fiefdoms are. A phoenix will undoubtedly rise in good time, though how long precisely is anybody's guess. It may well be prudent in the meantime to search for cooler air away from European equities, bonds and money markets whilst the fire rages yet more intensely.

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