How Will Europe’s Poker Match Play Out?
By Lee Jackson, published November, 2011
The following is an excerpt from Issue X of the free weekly financial newsletter The Opportune Time:
✦ The High-Stakes European POKER Showdown
✦ Two Types of Money ‘PRINTING’
✦ The Solution is FISCAL UNION, but When?
Currently occurring in the European Union (E.U.) is one of the highest-stakes POKER showdowns the world has witnessed. The showdown pits the European Central Bank (ECB) and Germany against the rest of the euro area. At the will of Germany, the ECB has avoided buying unrestricted quantities of sovereign bonds to prevent moral hazard. On the other side, the euro area excluding Germany claims unlimited sovereign debt purchases by the ECB would alleviate European credit woes. Surveys show market participants are split as to whether the ECB and Germany are bluffing. At stake are some or all of the following: the value of the euro currency (EUR), price stability in the euro area, the credibility of the ECB, the solvency and memberships of a few E.U. nations, the existence of the EUR, and the health of the global economy.
This high-stakes poker matchup can end a number of ways. As I discussed last week, there is almost no way the euro area can avoid pain in the short run. Historically, excessive debts do not dissipate without some sort of detriment. But I do believe certain outcomes will be better for the euro area in the long run. In my eyes, the long-run success of the EUR depends mainly on how soon the ECB folds its hand, and decides to ‘print’ unrestricted amounts of money to buy the debt of distressed sovereigns.
Before I walk through the avenues the ECB may take, I will define money ‘PRINTING.’ There are two main types of money ‘printing.’ The first kind is called quantitative easing (QE), and is used by central banks to ease credit conditions when benchmark short-term interest rates are at or near zero. Central banks typically lower interest rates to cheapen borrowing costs, which increases the flow of credit, expands the money supply, and boosts aggregate demand. The boost in aggregate demand counters slowing economic growth and falling inflation. But when interest rates are at zero and cannot fall any further, central banks, such as the Fed today, rely on QE to expand the money supply. During QE, central banks ‘print’ money to buy assets from banks. I put the word ‘print’ in apostrophe marks, because modern banking transactions are completed electronically. Hence, central banks digitally, not physically, ‘print’ money during QE. In the U.S., the Fed has ‘printed’ U.S. dollars (USD) to buy Treasury and mortgage bonds from banks. The Fed’s purchases have succeeded at preventing the prices of consumer goods from falling, an economic condition called deflation.
The other kind of money ‘printing’ is called debt monetization. Some analysts consider QE and debt monetization the same policy, but I distinguish the two from each other. In my eyes, central banks implement QE policies in response to the natural tendency of interest rates to fall. Although they have surprised many investors, U.S. interest rates have fallen dramatically since the 2008 financial crisis. People commonly say the Fed’s asset purchases lowered borrowing costs, but interest rates actually rose following the announcements of QE I and II, and fell sharply after the asset purchase programs concluded. After QE is enacted, interest rates generally climb in the short run and decline later.
On the other hand, central banks monetize debt when the natural tendency of interest rates is to rise, particularly amid credit or default risk. When debt is monetized, interest rates may fall in the short run, but resume rising in the long run. In my view, the ECB has been monetizing the debt of peripheral countries, notably Italy and Spain. Italian and Spanish borrowing costs each fell by about 100 bps in early August when the ECB announced it would buy the debt of Italy and Spain. But as shown in the chart above, Italian and Spanish borrowing costs have surpassed the levels at which the ECB intervened during the summer. The ECB intervened again at the end of last week, and while peripheral pain eased somewhat, I expect yields eventually to continue higher.
The bottom line is I do not believe the ECB has the ability to limit peripheral borrowing costs in the long run. Historically, debt monetizations almost always have ended with a default or high inflation. As I have said in the past, central banks are like aspirin, because they can provide only temporary pain relief. The European debt crisis must be resolved by governments, which possess the legislative ability and the capital necessary to solve the current dilemma.
Earlier, I stated that the sooner the ECB monetizes debt in unrestricted amounts, the more bearish I will be on the EUR over the long term. To date, the ECB has auctioned term deposits to offset the money supply increase caused by debt monetization. In my view, the ECB’s practice of sterilization, or offsetting bond purchases with term deposit auctions, has been a key reason why the EUR recently has not tested its 2011 low against the USD. If the ECB abandons its sterilization program and buys bonds in unlimited amounts, the incentive for governments, the only entities that can solve the crisis, to act will shrink. As painful as the bond market turmoil was last week, European leaders began discussing plans to create a euro area budget regulator and to lay the groundwork for a common treasury. A common treasury, or a FISCAL UNION, is the structural solution required to end the debt crisis. But unfortunately, I believe euro area governments will not establish a fiscal union until the debt crisis reveals the costs of not doing so.
Why is a fiscal union the solution to the European debt crisis? First, a fiscal union would make the job of the budget regulator easier. The E.U. would have far more success enforcing budget deficit limits for a single entity rather than for several.
Second, keeping certain sovereigns in the euro area, mainly Spain and Italy, may require a transfer of capital or a loan from the E.U. core to the countries in question. The European Financial Stability Facility (EFSF) is what I call a preliminary attempt by the euro area core to bolster the periphery. But full fiscal integration, though it may be uncomfortable for individual states in the short run, will be necessary to stabilize government bond markets in the long run.
Third, a common treasury would mitigate the bank run that is happening on the periphery. Bank deposits in Greece have declined roughly 20% since the start of 2010, and deposit growth in Italy has slowed to almost zero. Concerned their governments may be unable to insure their deposits, peripheral savers have been transferring their cash to other countries inside and outside the euro area. If the euro area had a common treasury, savers on the periphery would have as much confidence in their governments’ deposit insurance programs as savers in the core, and pressure on retail banks would be alleviated.
Fiscal union does imply the euro area core will need to shoulder some more of the costs of the other currency bloc members. Obviously, the core cannot afford to pay for the public debt problems of the entire euro area. Hence why I suggested in Issue IX that some countries, primarily the ones that have been shut out of the bond markets, may need to drop the EUR. Removing the weakest links from the currency bloc would lead to a sounder fiscal union in the long term. I will consider buying the EUR aggressively, if the E.U. announces plans for countries like Greece and Portugal to default and leave the monetary union.
Simultaneously, the countries like Italy and Spain, which are not bankrupt today but may be in a few months if market conditions continue on their current course, may require outside financial support. Newly elected Prime Minsters (PMs) Mario Monti and Mariano Rajoy will need to pass strict austerity measures to stabilize debt in the long run. Assuming the new PMs do, international lenders, such as the E.U. and the International Monetary Fund (IMF), still may need to support Italy and Spain until the present euro area recession ends. While I would prefer the E.U. and the IMF provide Spain and Italy with the credit necessary to weather the current storm, I would not disapprove of ECB involvement under specific conditions. The ECB should ease credit for Spain and Italy only after moral hazard risks have been reduced. Prior to ECB involvement, I would like to see Greece and possibly Portugal drop the EUR, and the Spanish and Italian governments commit to deficit reduction programs enforced by the ECB. Again, I believe the best course of action is for the ECB to maintain its independence. But ‘printing’ money after the EUR’s weakest members have left the union may not be the end of the world.
At the same time, I do not believe the ECB should sit idly until moral hazard risks are addressed. Liquidity is drying up in the euro area, as exemplified by the decline in the M1 money supply shown in the accompanying chart. Unlike solvency problems, liquidity concerns do fall under the purview of central banks. Higher funding costs have been forcing European banks to tap the ECB’s USD swap lines to access the global reserve currency. The ECB should cut its benchmark interest rate to cheapen funding costs, such as those in the Euro Interbank Offered Rate (EURIBOR) market. ECB rate cuts will not be a panacea for Europe’s liquidity crisis, but they will buy the banking system more time, as governments sort out sovereign solvency issues.
In summary, the ECB should rely on traditional monetary policy measures, namely cutting interest rates, until European governments implement the austerity measures and legal reforms needed to preserve the monetary union in the long run. Analysts commonly claim the ECB must ‘print’ now or watch the EUR disintegrate. But, I believe the risk of EUR disintegration is larger if the ECB ‘prints’ and relieves governments from market pressure in the short run. Market pressure is the force that will drive governments to enact the reforms necessary to preserve the EUR in the long run. If the ECB ‘prints’ too soon and creates moral hazard, I would expect to see multiple euro area governments go bust in a typical manner marked by debt monetization and currency devaluation. After governments take the actions needed to stabilize markets in the long run, international lenders, the E.U., and perhaps the ECB, may provide the financial support needed to stabilize markets in the short run. The sooner the ECB ‘prints’ to help euro area governments, the more of the EUR’s value that will be lost.
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