The ECB’s only choice
The ECB is under great pressure
from all sides to rescue Euroland’s sovereign debtors
with a round of quantitative easing. Such a solution is
totally against the principals and charter of the
central bank, and has so far been resisted, the ECB only
buying debt in the secondary market to lower the
apparent cost of funding for stricken governments. This
is little more than a sop, because no investor in their
right mind would buy government debt at a price
artificially inflated by ECB purchases. And nor should
the ECB support banks that continue to buy bonds issued
by insolvent governments.
The clamour for QE is entirely
Keynesian. The simple answer is that indebted
governments must cut their spending, and hard. By doing
so, much needed economic resources will stay in their
private sectors, which can lead to a surprisingly rapid
recovery: look at Iceland, which was forced by reality
to bite the bullet and whose economy is already
recovering. But this simple answer does not fit into
Keynesian ideals, which merely dismiss the private
sector as having lost its animal spirits, and therefore,
they argue, it is the duty of the public sector to take
charge.
It was hair-brained Keynesian
economics and socialism that got Europe into this mess
in the first place, and this should weigh on the
realists at the ECB in their deliberations. They now
have the practical task of keeping the banking system
intact. They cannot finance, or even part-finance,
Euroland’s government deficits as well. Just
underwriting Euroland’s banks might require up to a
trillion euros, which is inflationary enough; pumping
money into insolvent governments ad infinitum will
involve considerably more.
These governments are looking for a
soft touch: they have found it in the European Financial
Stability Fund, but that is too small for their
continuing negative cash-flow. The Chinese, after
expressing initial interest just to annoy the Americans,
have backed off. The PIIGS are now offering their
begging-bowls to the ECB. However, printing money for
governments to spend is the high road to hyperinflation.
The ECB are therefore likely to say no, to the
disappointment of Keynesians and socialists alike.
If the ECB does refuse to subscribe
for new government paper, the PIIGS governments will at
last be forced to face up to the reality of their
financial position. And who knows, if one of them gets
real, the others might follow. Keynesians everywhere
will probably advise them to leave the euro in favour of
their old softer money. This is like advice to a chess
player from someone who can barely think one move ahead,
because it would leave liabilities in hard euros, and
future funding in a collapsing drachma, punt, lira,
peseta or whatever. While exiting the euro would rapidly
force a default on any of the PIIGS ejected from the
sty, it would also offer the prospect of hyperinflation
for the ejected, and the position of Euroland’s banks
would probably be worse than if they stayed.
By dealing with the European
banking crisis in this way, the ECB will then be able to
tackle the separate issue of exchange rate policy, which
is another problem lurking in the background. With the
world on a dollar-standard and the Fed printing money
with gay abandon, the euro will continue to be strong.
This will intensify political pressures on the ECB from
all Euroland governments, worried about terms of trade.
That is a totally separate issue and should not be
confused with the immediate problem.
The ECB’s decision in this matter
will be for the markets a decisive indication of the
course of future euro inflation.
Alasdair Macleod
10 August 2011
