What ECB Must Do to Save European Economy
The European Central Bank (ECB) has acted much too slowly and without the consensus of its constituent countries during the current European sovereign debt crises. Rather than learning the lessons taught by the American Fed Reserve, Treasury and Congress in 2008, the ECB has equivocated, delayed actions and then subsequently had to reverse itself damaging its own credibility in the process. The head of the ECB, Jean-Claude Trichet, likely initiated the path to disaster by moving to raise European interest rates in early 2010 against the advice of other central bankers, including American US Treasury Secretary, Tim Geithner. This had the effect of further eroding already crippled Euro state economies including those of the southern tier of states: Greece, Italy, Portugal and Spain.
In the past two months, sovereign debt problems have grown worse with the indebted states paying higher interest rates, in large part because of the early 2010 ECB announced actions to tighten money supply. The lack of ECB commitment to support the over-levered states and work with them to reduce debt also contributed to the unwillingness of bond holders to continue lending at reasonable interest rates, pushing rates and budget deficits higher. It doesn't help government insolvency prospects that the debt has become more expensive to refinance and that higher interest payments further undermine national budget deficits.
There are only two ways out of these crises. And until very recently, Trichet and the ECB didn't appear interested in either approach. The least favored, other than breaking up the EU altogether, is to undergo sovereign defaults on the debt owed. This would allow for restructuring of the terms of payment through a process similar to bankruptcy, but without a court or judge. The resetting of bonds would lower interest payments and possibly principal payments reducing the burden on the distressed states. The problem with defaulting on debt is the ripple effects it will have through the global financial system. It would likely result in an unwinding of derivatives and a series of bank and investment fund failures in a replay of 2008. This would be very unsettling for world capital markets and could result in a second and deeper recession than in 2008-09 as lending and consumption freezes up. Higher unemployment and even civil chaos could be the result.
A second approach, more desirable for its less onerous consequences, would be to devalue the Euro by monetary quantitative expansion (QE), i.e. printing money. Of course, today money is not physically printed to increase the amount in circulation. It happens via accounting entries to each countries currency account at the ECB. A CNBC story today proposed that 10% of GNP be credited to each EU country's account. This would immediately increase national currency balances in Euro terms. Currency is an asset on the national balance sheets, so immediately goes to reduce the deficit, if artificially so. By having more currency in circulation without any commensurate liabilities or national productivity increase as measured by GNP, it would also serve to devalue the Euro by the same 10% amount. This is essentially what has been taking place in the marketplace anyway, as the Euro has lost over 20% of its value versus the American dollar so far in 2010. But to have the market make the adjustment can be unsettling for global markets and not as controlled as if the ECB manages the process.
The devalued Euro currency would be used to repay sovereign bond debt. Since the Euro would be worth less (an additional 10% reduction on top of the 20% devaluation to date in 2010), the bonds would be worth 30% less in an alternate currency, including gold. Interest payments on the bond principal would also cost 30% less in alternate currencies. So, in this way, bonds are reset to a lower principal level, without the negative global consequences associated with forcing bond holders to accept changed terms through the process of default.
If this inflationary action is not taken, the debt reduction programs underway in Europe will reduce currency in circulation and will act to deflate the Euro. Deflations result in a higher value currency versus alternate forms of currency, including gold. Without any counteracting inflating of the Euro, it will rise against the US dollar, possibly to 1.50 or 1.60 EU to the $1.00. This will further hurt European competitiveness and will extend the global economic contraction.
Here is a link to the CNBC article by Warren Mosler that recommends devaluing / inflating the Euro.
As I post this article, the economic leaders of the G20 nations are meeting in Busan, South Korea to discuss global economies and the policies needed to continue the recovery from the 2008-09 debt crisis. We are at a critical moment and the central bankers and government leaders must make the right policy moves on monetary policy, debt management and economic growth. Tim Geithner has been pressing the European nations and Japan to encourage consumption so that America and China do not have to bear the entire global load.
The next 2-4 weeks will tell the story whether the Europeans get it right and manage their currency and sovereign debt in a way that does not panic the capital markets and kill the global economic recovery. There is some promising news as on June 2, Trichet reversed the course previously set and offered to extend the low rate environment to ease the pressure on the over-indebted Euro states.
