Not a Skeptic, Just a Realist

Draghi Still Isn’t Winning Over Skeptics – MarketBeat – WSJ.

If you offer an opinion outside the mainstream, you are labeled a skeptic. A better term would be realist, because the mainstream is very optimistic regarding Europe. Optimistic people label those who do not share their optimism as either pessimistic or skeptical.

This bond buying program changes nothing. Europe is in the midst of a funding crunch and desperately need foreigners from outside Europe to purchase its bonds, particularly those of the PIIGS. Due to the risk of insolvency, investors are demanding higher premiums for PIIGS debt.

Interest charges are a component of national budgets so a country affected by higher rates can either raise more money through tax increase, cut spending on social programs or borrow more money. These are not exclusive choices; a government could choose a blend of these options, too.

What people do not realize is that there is no magical fourth option. Let’s discuss why that is so.

The bond buying plan looks like that fourth option, but it will eventually cause one or more of the three options I outlined above to occur, just in the richer countries supporting the poorer ones.

There is no such thing as free money. When the ECB begins purchasing bonds, it will be withdrawing an equal amount of euros from the financial system. It will also insist on the failing countries enacting “reforms,” which will lead to shrinking economies in these countries. See Greece for an example of what happens during austerity.

The ECB will purchase bonds on the open market, mostly from banks. Then, they will turn around and sell these banks the bills from the ECB to mop up this liquidity. The result is that the amount of money available for lending has not changed.

Remember those austerity conditions? Well, they will reduce tax revenues, which means that the struggling countries will have to sell even more bonds to finance themselves. Increasing the supply of these bonds while holding demand levels consistent will have the affect of lowering bond prices or raising the interest rate. This will lead to more purchases by the ECB. This will also cause the bonds that the ECB already owns to decrease in value.

The ECB is owned by the countries of the EU. If it loses value, then the taxpayers of the EU are on the hook for these losses. The rich countries will have to increase their contributions to the ECB, and they will have to cut their own budgets, raise taxes or increase borrowing to pay for this.

Even though nothing changes in the long-term, in the short-term the ECB has bought some more time. Unfortunately, using the Greek situation as a guide, this time will not be used wisely.

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