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“Debt is a hand grenade with the pin removed….”

by Aaron McCormack on October 19, 2011

Yes, it is getting a little depressing to feel that I am always writing about the downsides to the current situation.  I am a natural optimist, which makes it doubly difficult.  But I will tell you what is more frustrating….it is having a clear sense that people at large are being misled about the current economic situation.  I don’t know if they are being deliberately misled, or if leadership in the US and Europe really do believe in their analysis and solution.  Either way, we are wasting precious time and resources on fixing the wrong problems.

In business, if you misdiagnose your predicament you are in serious trouble.  The market will expose you.  Over time you will have to come to terms with the problem (or missed opportunity) and deal with it, or your business will die.  A key difference in the world of public affairs is that bad ideas get to linger for a very long time.  Eventually, countries or cities or other public bodies can collapse under the weight of all their bad ideas.  The process takes a lot longer than it does in the business world and the endgame is usually more chaotic and catastrophic.

The core challenge, to repeat previous blog posts, is debt.

Debt, it is said, is a hand grenade with the pin already pulled.  We can pass it around, but sooner or later it will explode.  It is just a matter of whose hands it is in when it does.

It cannot be made to magically disappear.  If you forgive the borrower entirely, the lender pays 100%.  If you insist on repayment, the borrower pays 100%.  Right now the Irish government is insisting on carrying the debt grenade created by the Irish banking system.  It is slowly but surely exploding in the hands of the Irish people.

Normally, in the capitalist model, the borrow and lender will share some form of accountability if the debt cannot be fully paid by the borrower.  But, lets be clear, the debt still gets paid 100% – some by the lender and the rest by the borrower “absorbing” their loss.

If we consider the monies lent to now-bankrupt institutions like Irish banks or the Greek state, and consider who the lenders are, we can see why the EU is so keen to ensure that as much of the debt as possible is paid by the borrower.  In the case of Ireland, this is why the Irish government are now paying back, in full, the bonds of the most bankrupt of bankrupt banks, Anglo Irish.  In Greece, rather than do the sensible thing and allow Greek debt to be cut in half (and have the rest absorbed by the lenders…) we see unbearable austerity and the ensuing unrest.  Worse still, the austerity and strife kills off any chance of growth…the only long-term saviour for a country in economic trouble.

When the borrower simply can’t pay, the grenade automatically ends up entirely back in the hands of the lender – and it explodes.

The actions to date of the EU has simply been to protect their core – the French and German banks who lent the money in the first place.  They have tried to create firewalls that would stop the debt contagion spreading – leaving the hand grenade with the people of Ireland and Greece.

Although the market has seen through these moves, the EU is now insisting that the Euro can be saved with the creation of a larger fund of money (called the EFSF or European Financial Stability Facility) gathered from member states that will take more money from European taxpayers and be used to bailout  banks.  It is a myth that some of this is going to nation states – when money is given to Greece, it is in reality given to Greece so that it can pay it onward to the banks that it borrowed from.

Unfortunately this will not work.  The debt situation in Europe is much too large.  The proposal by US Treasury Secretary Timothy Geithner to fix our debt problem with further leverage of this ESFS (by borrowing 10X the money in the fund, presumably from the Chinese and the Middle East) shows how far from reality even the most senior leaders have drifted.

The EU has now wasted billions of euros, thousands of man years of effort, and most of its credibility trying to find ways to magic the “debt grenade” out of existence.  The EFSF is simply going to be another waste of time and money.

The reality is that many European countries, and most of their banks, are sitting on debt grenades that they can no longer escape.  The continent needs to face up to this reality and deal with it head-on.  That is the only way we can turn our heads toward re-establishing comparative advantage in what is now a global war for jobs.

It will be unbelievably painful, but it must be done.  This is not a recession like previous cyclical boom and bust recessions.  The world has fundamentally changed over the past twenty years and for the past decade the Western debt binge has seen us lose touch with the realities of global competition.  We won’t magic the debt away with inflation or brush the hand grenade under the carpet with the EFSF.

This is not an ordinary recession – it will require extraordinary leadership to escape it.

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