More Eurocrisis Chatter

Showtime for Draghi at European Central Bank Meeting – NYTimes.com.

This article presents two common fallacies that euro-pundits make when analyzing the Eurocrisis. First, they believe that the ECB has the power to stop the crisis. This belief manifests itself in the common interventionist theme when intervention fails; specifically, it is not the intervention that is flawed it is just that we have to do more. Read this passage from the article:

The European Central Bank has bought bonds before under a program begun by Mr. Draghi’s predecessor, Jean-Claude Trichet. But that ultimately failed to hold down borrowing costs for countries like Spain because the bank did not commit enough money or show enough determination. Any new round of bond-buying would have to be more impressive.

The reason that the bond buying did not hold down rates is because the periphery nations are approaching illiquidity to be followed by insovlency. Even if the ECB bought all of the periphery bonds, the PIIGS would have to pay the money back. Their sclerotic economic systems are stifling the economic growth and corresponding tax revenue increases that are needed to pay off the debts. Rather than stiffing private investors who bought the bonds, they will be stiffing the ECB because they simply do not have the money to pay.

Now, please read this passage for the second fallacy:

In theory, the E.C.B. could cap bond prices simply by declaring that it would not tolerate market interest rates for Spain above, say, 7 percent. Any speculator who might want to bet against Spanish debt would confront the risk of big losses if the E.C.B. bought bonds in grand style on the open market to drive down yields, the effective interest rates.

The euro-pundits are operating on the assumption that current illiquidity problems can  be cured without addressing the looming insolvency issues.  The current funding issues, or sovereign illiquidity problems, exist because investors believe that they will not be paid. If you decide to address the insolvency, you can buy time with measures to provide liquidity while the economies slowly adjust to the the economic reforms. However, there are only half-hearted attempts at freeing markets and raising pension ages. Certainly, not enough has been done to assure anyone that these countries will be able to pay their debts in the future.

Now, let’s take the ECB cap down to its logical conclusions. Say the ECB announces that it will buy periphery debt in unlimited quantities to keep the rate below 7%. I believe that such a statement may actually keep rates down, but there is a catch. How will the ECB pay for all of this debt? The answer is that it will print oodles of euros to accomplish these open market operations. When you create more currency, you devalue it. Foreign investors may not lose money from deteriorating bond prices, but they will lose money from the decreasing value of the euro. See the trap that Europe has fallen into.

There is only one way out of this trap. The periphery area economies must undertake dramatic economic reforms. While we wait for these reforms to work, the ECB can provide liquidity on a temporary basis. Anything else will simply lead to crisis.

https://dareconomics.wordpress.com/

 

 

Advertisements

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s