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Another Day, Another Bailout

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Well, the Cypriot banking crisis has been “resolved.” It is being reported that the government in Nicosia has agreed to a deal with the European Union (EU) and International Monetary Fund (IMF) lenders. The deal involves a large loan from the European Central Bank (ECB), the imposition of austerity measures and capital controls, and the restructuring of the country’s banking system.

Several eurozone countries, such as Germany, must also sign on to the bailout deal, which might take another few weeks. EU officials said they expect the whole program to be approved by the end of next month.

Last week, the world was shocked to hear about a plan to save Cyprus’s troubled banking system: a levy that would have automatically withdrawn cash from every single private account in the country.

The plan was met with widespread public opposition, and in a stunning development Cyprus’s parliament voted to reject the measure, with none of the 56 members voting to accept it.

The immediate cause of this latest financial panic was the exposure that Cyprus’s two largest banks — the Bank of Cyprus and the Cyprus Popular Bank (aka Laiki) — suffered when Greece defaulted on her bonds.

The ECB will now be called on to create billions of digital euros to cover the losses of the Cypriot banks.

During a recent appearance on Russia Today, Lew Rockwell cut through all the financial smoke and mirrors by asking his interlocutor the following questions:

Why should the members of parliament tax the average guy in Cyprus to bail out the rich banks? Of course, they shouldn’t be doing it. They should follow the path of Iceland: let them go under.… All of Europe, like all of America, is a bankocracy. Everything is being run for the banks. This is all about bailing out the banks. It’s not about bailing out Cyprus; it’s not about bailing out Greece or Italy or Spain.

He continued, “Nobody in Cyprus should be taxed to pay back the bonds. They never agreed; average guys never agreed to pay those bonds. They should repudiate the bonds and start afresh and no longer rip off the average guy for the benefit of the rich bankers.”

Mr. Rockwell’s critique of the situation is spot on.

Cyprus’s banking system is being recapitalized with fiat money created by the ECB.

The moral hazards here may not be as conspicuous as in other bailout schemes, because the two institutions at the epicenter of the crisis are being penalized. Laiki will be shut down, and the Bank of Cyprus will inherit Laiki’s debt to the European Central Bank — all 9 billion euros of it.

But in the final analysis, the deal is being financed by yet another currency devaluation. Nothing has really been solved. It’s just more money being created to paper over bad debt.

Now, the reason why the whole world is focusing on Cyprus, a tiny island nation with a small economy, is that her financial troubles are threatening to start a chain reaction that could bring down the entire global financial system. Bank runs in Cyprus could spark similar panics in Europe and even in the United States.

This should raise a few questions.

If the current financial system is so fragile, is it worth saving? Should not radical reforms be implemented to address the core problem? What is the core problem?

Well, the EU’s current plight has been created by excessive government borrowing. That much is illustrated by the member states’ gargantuan debt, especially in the so-called PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain). The same can be said of the United States, where the debt-to-GDP ratio is now 100 percent.

But the reckless borrowing and spending on both sides of the Atlantic has only been possible because of the existence of fiat money.

Had the global financial system been based on sound money, that is, on a currency subject to 100 percent redemption upon demand, there is simply no way that the European Union, or the United States for that matter, could ever have become so indebted.

Since sound money cannot be inflated, any increase in borrowing, either by the government or the private sector, would have resulted in higher interest rates as the borrowing depleted the amount of loanable funds. This would have curtailed further debt creation. It is only through the intervention of central banks — endowed with the power to create money ex nihilo — that interest rates have been able to remain artificially low.

Cheap credit is only possible with easy money. The problem is that the debt it creates eventually has to be paid back with interest. Governments in Europe and North America have been desperately trying to forestall that day of reckoning with more inflation.

And such inflation is only possible under a system of fiat money. As Milton Friedman famously observed, “Inflation is always and everywhere a monetary phenomenon.”

Ironically, the trouble in the eurozone has led some to boast of the relative health of America’s financial system.

But the vaunted stability of U.S. banks is based on a weak foundation of artificially low interest rates. Should interest rates return to their historic levels, as they eventually must, the value of the American banks’ highly leveraged bond and mortgage portfolios would plummet, sending these financial giants into bankruptcy overnight.

This could very well happen, because as the Fed continues to monetize U.S. government debt, inflationary pressure grows. This is what happened in the 1970s, when the nation suffered “stagflation.” But back then the United States was still a creditor nation, and the federal government’s budget deficits were relatively small. So the Fed was able to raise interest rates eventually without causing too much social disruption. That is certainly not the case today.

The current national debt is now close to $17 trillion, and Congress is adding $1 trillion or more to the figure every year. Now, the only reason the Treasury has been able to service this staggering debt load is the artificially low interest rates being provided by the Fed. This keeps debt-service payments to a manageable level (roughly $300 billion per year). Should interest rates return to their historical norms (say, 5 percent), debt-service payments could easily treble, forcing Congress to make massive across-the-board budget cuts to avoid an outright default on the national debt.

Consider the political ramifications of Congress cutting a trillion dollars or more from discretionary spending just to stay current with its creditors. How will the tens of millions of Americans now dependent on government largesse for their daily sustenance respond to true austerity?

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    Tim Kelly is a columnist and policy advisor at The Future of Freedom Foundation in Fairfax, Virginia, a correspondent for Radio America’s Special Investigator, and a political cartoonist.