THE BLOG
06/14/2010 05:12 am ET | Updated May 25, 2011

IMF Prepares for Financial Meltdown

The IMF has been making a lot of noise recently, but their biggest move almost managed to slip through completely unnoticed.

The Executive Board of the International Monetary Fund (IMF) today approved a ten-fold expansion of the Fund's New Arrangements to Borrow (NAB, and transfer the Fund's premier standing credit arrangement into a more flexible and effective tool of crisis management. The NAB will be increased by SDR 333.5 billion (about US$500 billion) to SDR 367.5 billion (about US$550 billion), representing a major increase in the resources available for the Fund's lending to its members.

This IMF program didn't even exist until a year ago, when the IMF began issuing SDRs for the first time since the 1970's. The IMF has only sold SDRs in times of global financial stress. It makes a person wonder "Why now?" Why is the IMF suddenly tripling its lending facilities? What do they know that we don't? To answer that, let's look at the announcements of the past few weeks.

The IMF has been busy issuing warnings over the past couple weeks. If this massive expansion of lending resources is a direct reaction to their recent statements, then we are looking at a severe financial shock in the near future.

Two weeks ago the monetary fund's chief, Dominique Strauss-Kahn, said that Europe needed a "Fire Brigade" to deal with any potential banking crisis.

"What I think is needed is a European Resolution Authority, armed with the mandate and the tools to deal cost-effectively with failing cross-border banks," the monetary fund's chief, Dominique Strauss-Kahn, said in the text of a speech delivered to a conference on banking supervision in Brussels.

The weakness of the European banking sector is not a secret. German banks are unable to lend. High unemployment in Spain is threatening their banking system. Sweden's banks were overextended in the Baltics. Britain's banks came within just three hours of total collapse. Ireland's banks require another round of bailouts. Austrian banks are overexposed to eastern Europe.

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The list goes on and on.
In fact, Europe's financial system weakness is so well-known that American fund managers consider Europe to be a 'No-Go Zone'.

Of course Greece is getting the lion's share of the blame for this condition. The on-again off-again bailout from the EU/IMF has been the gossip of the markets for months.
The term PIIGS even has its own wikipedia page.

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Yet, even while the political and financial leaders talk about the need to prepare for more bank bailouts, they criticize the governments for taking on too much debt. As if the two linked concepts aren't directly related.

It's an amazing level of gall. These are the same guys who fully supported the deregulation of the financial industry. They back the public bailing out private banks for taking stupid risks while paying themselves obscene bonuses, and justify it as a "necessary evil". They then lecture the governments about spending too much on social services, as if much of those deficits didn't come about because bank bailouts, tax cuts for the rich, and useless wars, none of which they ever seemed to find a problem with.

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To put it another way, our political and financial leaders have a problem with deficit spending in ways that benefit taxpayers. They don't have a problem with deficit spending in ways that benefit banks and large corporations because its "necessary".

Saving the multi-million dollar bonus of a Wall Street bank executive is necessary, but helping out the 107,000 homeless veterans on any given night is a luxury we can do without.

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And speaking of bailing out banks, there are indications that something dramatic is going on behind the scenes. $421.8 Billion in a single week requires some sort of explanation, an explanation that I haven't seen anywhere.

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The problem is that the bankers and politicians are right about one thing: we are too heavily in debt. The levels of deficit spending are totally out of control and unsustainable.

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A few days ago Dominique Strauss-Kahn warned about public debt levels. However, that wasn't the announcement that needed attention. The really scary report came from the Bank of International Settlements a week ago.

"The aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to the boiling point", said the Swiss-based bank for central bankers -- the oldest and most venerable of the world's financial watchdogs. Drastic austerity measures will be needed to head off a compound interest spiral, if it is not already too late for some.

Official debt figures in the West are "very misleading" since they fail to take in account the contingent liabilities and pension debts that have mushroomed over recent years. "Rapidly ageing populations present a number of countries with the prospect of enormous future costs that are not wholly recognised in current budget projections. The size of these future obligations is anybody's guess," said the report. The BIS lamented the lack of any systematic data on the scale of unfunded IOUs that care-free politicians have handed out like confetti.

Britain emerges in the BIS paper as an arch-sinner. The country may have entered the crisis with a low public debt but this shock absorber has already been used up, exposing the underlying rot in the UK's public accounts.

Of course Britain's "shock absorber" was used up bailing out its banks, not by spending it on public pensions and health care. The reports never seem to mention things like that. On the other hand, it's a matter of math. The deficit spending cannot continue. You can't make 2 + 2 equal 5. The savings and capital simply aren't there. 2010-04-14-supplydemand.jpg

"Current fiscal policy is unsustainable in every country (in its study). Drastic improvements in the structural primary balance will be necessary to prevent debt ratios from exploding."

...Historical data shows that once public debts near 100pc of GDP they act as a ball and chain on wealth creation.

If countries do not retrench quickly, they will create a market fear of "monetization" that becomes self-fulfilling. "Monetary policy may ultimately become impotent to control inflation, regardless of the fighting credentials of the central bank" it said.

Which brings us back to the IMF's new lending capabilities. Debtor nations being forced to monetize en mass because they can no longer support their spending habits causes price inflation, which hurts almost everyone. But it hurts the people who hold that nation's debt the most. The reason why the IMF dusted off the SDR program in 2009 was because of pressure from the world's lenders - namely China.

China's central bank chief on Monday proposed a sweeping overhaul of the global monetary system, outlining how the dollar could eventually be replaced as the world's main reserve currency by the Special Drawing Right (SDR).

"The role of the SDR has not been put into full play due to limitations on its allocation and the scope of its uses. However, it serves as the light in the tunnel for the reform of the international monetary system," Zhou said.

"The price is becoming increasingly high, not only for the users, but also for the issuers of the reserve currencies. Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws," Zhou said.

The Asian creditors of the world are getting nervous holding dollars, and recently Euros. They can see that another downleg to this Great Recession could be catastrophic. They want to diversify, but they can't start selling without crushing the value of their remaining holdings.

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That's where the SDR comes it. They simply swap out their dollar-based debt for SDRs.
It should be noted that SDR is merely a ledger entry. Its is a composite of major reserve currencies, rather than a new currency by itself, but it does help diversify.

The reason for the IMF rolling this out now might be two-fold: 1) an approaching financial crisis that the IMF needs to build up its reserves to prepare for, and b) the demands of Asian creditors to diversify their holdings in order to help avoid the impact of that coming financial crisis.

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When you look at this chart above, and see the projections of debt/GDP ratios of 200%, 300%, and 400% by 2040, remember the quote above: "Historical data shows that once public debts near 100pc of GDP they act as a ball and chain on wealth creation."

So if 100% public debt to GDP is a ball and chain, then what do you think 300% debt/GDP does to an economy and its ability to pay its debts?