"...we've heard all sorts of propositions
that the European Central Bank (ECB) "must" begin printing money
to bail out Italy and other countries, because "there is no other option."
There are ...basic difficulties with this idea.
...the ECB, under existing European treaties,
has no such authority, and the prohibitions against it
are very explicit.
...the ECB is prohibited from providing funds to "leverage"
the European Financial Stability Facility (EFSF).
Changing that would be far more difficult
than many market participants seem to believe,
because it would require an explicit and unanimous change
in the EU Treaties that AAA rated countries
such as Germany and Finland vehemently oppose.
...the Treaty on European Union...is very specific
in restricting the ECB from assisting individual governments.
Article 123 of the Treaty on the Functioning of the European Union
prohibits the ECB from providing any type of credit facility
to central governments
(and specifically "any financing of the public sector's obligations
vis-a-vis third parties").
...the ECB Governing Council cannot simply take decisions
- even by majority vote - that violate the explicit EU rules.
In fact, the ECB itself is subject to recourse
for unauthorized actions.
Article 340 provides that "The European Central Bank shall,
in accordance with the general principles
common to the laws of the Member States,
make good any damage caused by it or by its servants
in the performance of their duties."
...Culturally, the respect for the rule of law,
and the abhorrence of inflation,
are aspects of the German mindset
that are less easily shaken than Americans might believe.
...Absent fiscal coordination and an explicit change in EU treaties,
it is unlikely that investors will simply wake up one day
to the news that the ECB has suddenly had a change of heart
and is bailing out distressed European countries.
...ECB buying might help to address immediate liquidity issues
of distressed European countries,
but it would not address long-term solvency issues,
and would in fact make them worse.
...ECB bailouts would destroy the ECB's credibility...
...the EFSF has many of the characteristics
that the U.S. securitized mortgage market had in 2007
- attempting to provide credit to borrowers
that actually weren't creditworthy,
by repackaging the debt in a way
that it could still get a AAA rating...
...while ECB buying of distressed European debt
can address short-term liquidity problems
...it does not address ...the fact
that they are mathematically unable to make good on it
because the debt violates the no-Ponzi condition.
...even if the ECB was to buy the debt
of distressed European countries with printed money,
the inflationary effects would likely be far more swift
than anything we've seen in the United States.
This would not "save" the euro,
but would simply destroy it by other means.
...large-scale ECB purchases of distressed sovereign debt
...would have much swifter inflationary effects
than anything we have seen in the United States.
...if the Federal Reserve creates a massive amount of currency,
it will not be inflationary provided people are absolutely convinced
that the dollars will only hang around for a short period of time.
If they ever become convinced that the new dollars are permanent
(and especially if there is not an ongoing credit crisis to create safe-haven demand),
the marginal value of each individual dollar would decline,
and inflationary pressures would emerge.
...it should be clear why the Federal Reserve's tripling of its balance sheet
has not resulted in near-term inflation.
There is significant demand for the U.S. dollar as a safe-haven currency,
the creation of dollars is still viewed as temporary...
The problem for the Fed will emerge in the back half of this decade
if (and I suspect when) it becomes clear
that there is no easy way for the Fed to disgorge its balance sheet
without causing disruptions in an economy
where the U.S. debt/GDP ratio will then be well above 100%.
At that point, the dollars that the Fed has created
may be looked upon as more permanent than the markets bargained for,
and we are likely to see inflationary pressures.
Against this backdrop,
consider a situation where the European Central Bank begins to print new euros
in order to purchase the debt of distressed European countries
that are deeply indebted and likely to become more so
(barring a major restructuring of their existing obligations).
In this case, would people be likely to view the newly created euros
as temporary or permanent?
Would people be likely to seek the euro as a "safe haven,"
or would they seek the relative safety of some other currency?
...a move to buy distressed European debt by creating euros
would be seen as permanent money creation,
and that far from seeing any safe-haven demand for euros,
we would instead see a flight from the euro.
As a result, European inflation would predictably accelerate.
...if the ECB buys those bonds,
and they don't pay off over the long-term,
the ECB will have given a fiscal subsidy to those distressed countries,
and Germany will end up bearing most of the cost.
Having created new euros to purchase distressed sovereign debt,
it would be unlikely that those new euros
would ever be removed from the system...
...the call for massive ECB purchases
...is not simply a call for a liquidity-providing intervention,
but is an attempt to address a solvency issue.
Liquidity issues can often be addressed
through temporary increases in the stock of money,
but to address solvency issues,
you have to print permanent money.
A memorable instance of permanent money creation
as a means of financing budget deficits was in 1922,
when Germany ...began printing money
in order to keep paying striking workers
...even though they were not producing goods and services.
The shift to printing money
triggered an immediate flight away from the German mark.
The resulting hyperinflation is well-remembered by the German people
even if the rest of the world has forgotten.
...the Greek 1-year yield hit 240%...,
with Greek debt of every maturity trading below 37% of face value...
...This suggests a credibility problem
for the widely assumed 50% writedown figure
...We wonder where this debt is currently valued
on the balance sheets of European banks.
...if the ECB is to expand its purchases of distressed European debt,
it would be a solid effort to impose centralized control
on the fiscal policies of the individual European member states.
This will be a painstaking process,
subject to unanimous approval by EU member states.
...the average maturity of European government debt is only about 7 years.
Given the nearly 40-to-1 leverage common among European banks,
it appears likely that much of the European financial system
will be nationalized before this is all over.
...I suspect that the best way
to address the problems of peripheral European countries
(which have structural, not temporary fiscal issues)
will be for these countries to extricate themselves from the euro
as their existing bonds mature,
by issuing new debt that is convertible into their own currencies.
...they would eventually proceed
with a combination of restructuring, fiscal reform,
to restore their individual economic competitiveness."