10 November 2011

Europe’s Debt Crisis: Tragedy or Show?

Is the current Europe’s debt crisis a tragedy or a show? One or another, the latest headlines in the news would have sounded unbelievable just a few years ago:
* “Euro zone split fears as EU dithers on Italy” (Reuters, 10 Nov 2011)
* “EU’s Barroso warns about cost of splitting euro zone” (Reuters, 9 Nov 2011)
* ...
Under such headings there are repeated talks about the Europe's debt crisis having “deepened dramatically” and the Italy’s borrowing costs having reached a “breaking point”, about Greece being just a sideshow, about Christine Lagarde, head of the International Monetary Fund, telling that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade." Can all this be happening? Can it be happening right now?

Yet the happy (or relieved?) faces of the World’s political leaders on the “family photo” below, taken at the (pretty inconclusive) G20 Summit in Cannes, seem to tell a different story.

They seem to tell that the leaders of the so-called advanced countries know (or believe that they know) what the solution will be. Their answer includes inflation, no matter the exact form or wording or exact timing. As I explain below, this does not necessarily mean that the European Central Bank (ECB) is going to announce the start of money printing (or “Quantitative Easing” or “Monetary Easing”, the terms that sound more professional). The later is strongly opposed by Germany, although there are clear pressures by the markets, by some of the most prominent economists, by the bank analysts, by the policymakers outside the eurozone and even by the other members of the eurozone.

What concerns the leaders of the largest emerging economies then they just must feel pleased about their spelled out importance in the global arena. Indeed, I do not even remember when (if ever) I last heard or read such a pleasing speech as the address to the 2011 International Finance Forum by Christine Lagarde in Beijing, November 9, 2011. China just must have felt lifted up when hearing the charming Managing Director of the IMF telling things like: “It is always a pleasure to return to this magnificent country,” “...China is very much a leader. Just look at its remarkable achievements over the past three decades ...,” and “...China is now in our top three shareholders. So China is a very important member of the IMF...”

“Family pictures” and pleasing speeches are the beautiful side of the story. The terrifying (or exiting) news seem to shed light to the ugly part of it. However, at the end all of this is just a surface or show, whatever one may want to call it. I mentioned inflation and that’s what I’d like to discuss here: Monetary easing in Europe.

First, let me point out that there is some data that should make savers vigilant, namely the recent inflation statistics in the eurozone. The ECB’s Harmonised Index of Consumer Prices (HICP) which is aimed to be around 2% a year in the medium term is reaching new highs. For example, in September it was close to 3%; the same in October. The other fact is that since the beginning of 2011, the ECB’s balance sheet has expanded by about EUR 325 billion or 16.2%, and is now larger than ever before. This despite of the fact that the increase in liquidity as a result of the bond purchases made in the context of the Securities Markets Programme (SMP) is told to be fully sterilised by means of specific operations to reabsorb it.

Secondly, we should ask if there are any realistic non-inflationary solutions available. (Note the underlining of the “realistic”; we also assume that the goal is to keep eurozone together, despite that some members may quit and/or we may end up in a two-speed Europe. In this analysis we forget for a while what Martin Wolf or Paul Krugman or anyone else may say about the improbability of eurozone to survive.)

One option would be a deflationary adjustment in the troubling countries, together with structural reforms, falling wages, increasing taxes etc. This has been tested in Baltics, for example, but apparently does not work for the so-called euro area periphery, at least not in the extent necessary. Furthermore, if large countries Italy and Spain and ultimately France would take the deflationary adjustment very seriously, this would be a hard hit to the rest of the Europe, and not only. The current economic and financial equations just do not work that way; these equations assume that there are consumers. To summarise, the deflationary scenario is not really an option. (This does not mean that the structural reforms and increasing efficiency are unnecessary; on the contrary: they are unavoidable from the sustainability point of view. These are just the economic and financial equations that do not add up and that ultimately need to be fixed.)

The second alternative would be forgiving part of the government debts or literally: allow some governments to default with a rather significant part of their debts. This does not need to be labelled as “default”. It may even be structured in a way that it would not trigger payouts of credit default swaps (CDSs). Something similar has been done with Greece’s debt already. The problem is that without monetary easing, banks would not survive this for sure. So again, this is not really an option.

Or maybe to introduce a social security system for countries so that those “between the wheels” would receive help (free money) as long as they need it (read: indefinitely)? The first implementation of this “social security” right now would be starting paying interests for Italy (if there were no interest payments, then Italy’s government budget would be more-less balanced). The problem is that it’s a bit late to start with this right now. No country has paid into such a system and hence, there are no dedicated funds available for that.

In short, there does not seem to be any realistic / boradly acceptable non-inflationary solution for the eurozone available at the moment. No wonder that many are thinking about Germans as unreasonably obstinate. (Ok, they have a bad historic experience, but still; ok, a central bank should be independent from governments, but this is an emergency situation; etc.). “Why are you begging China for help if the ECB could simply print money,” they ask. Printing money seems to be so simple and so obvious solution. Germany’s leaders are then referring to the moral hazard and to the fact that the deficit countries would not have a good enough motivation for implementing the necessary structural reforms. That’s a valid argument, of course.

After all, Germans have the most to lose from an inflationary policy: conservative people are generally losers in an inflationary environment and Germans have been more conservative than many others.

Yet there is one more thing that is not being said out loudly: it’s still too early for the ECB to start printing money. Yes, it’s still too early, even if the ECB is told to be the only effective bulwark against market attacks. Namely, there are at least three alternatives for the monetary easing in the eurozone that all are more preferable at first than simply giving up to the market pressures:
a) to involve at least some external investors using the leveraged European Financial Stability Facility (EFSF) and/or via receiving direct loans from the IMF,
b) the scheme of the Securities Markets Programme (SMP) and various other (liquidity) measures by the ECB,
c) and (later than (a) and (b)) the Eurobonds.
ECB may and at some point will be forced to “print” the eurozone out of the debts, but there are other more respectable methods before that. No explanations to the electorate. And these other methods enable sharing the costs of inflation with the other countries outside Europe after all.  .

I explained the leveraged EFSF in one of my earlier posts: Leveraged EFSF and Redistribution of Wealth“. Clearly, it will be a tricky complicated thing which is designed to access more external funds with as little own money in play as possible. The only problem is that the external investors may be too susceptible. Indeed, the EFSF has already experienced some cool reception when trying to issue more bonds... That’s probably why C. Lagarde is talking so nicely with Chinese. Ultimately, there will be some “fools” still (and to be fair, some first short-term investors may even win given the partly artificially generated demand for AAA-rated securities).

Now the more interesting question: how does the Securities Markets Programme works in terms of the monetary easing? Here I’d cite the view expressed by Morgan Stanley on 23 September 2011:
“The ECB's SMP transforms national bond markets into a euro area common liability, a liability that is backed by euro area governments via a loss-sharing agreement [...].  This is obvious from the sterilisation of the SMP purchases.  The ECB has several alternatives to sterilise its bond purchases: offering short-term deposits or issuing ECB debt certificates.  Currently, the ECB is using short-term deposits to remove the liquidity added by the SMP's bond purchases from the interbank market.  If the ECB instead decided to issue ECB debt certificates, it would be obvious that it is hovering up national government debt from the secondary market (rather than the interbank market) and transforming it into a euro security on its balance sheet.  But this is not different for the short-term deposits it currently offers.  Given that the short-term deposits are eligible collateral for the ECB's refi operation, they are quasi-money anyway.”
In short: despite of the sterilisation measures, SMP is inflationary anyway.

Eurobonds are not that hotly debated right now; they will come a bit later in the row (if still needed). The intention behind however would be very similar to the one behind the EFSF: monetary easing via the simpler/cheaper access to the external funds.

Once again, it seems that we have a show here – but not a show with a happy end for every participant and every spectator. This show seems to have other purposes than simple entertainment.

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