Alasdair Macleod – 10 August 2011
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.