The latest plan out of Europe has everyone breathing a huge sigh of relief. It almost looks like the crisis is over. But it’s not. This was really nothing more than a very hard kick of the can. The reasoning is simple and I’ll go over it again.
First of all, Europe has a crisis because they instituted a single currency without any internal rebalancing mechanism. That is, there is no floating exchange rate between nations with a trade deficit or trade surplus because they all use the same currency. And there is no central treasury to rebalance economic disparities via taxes and spending. And lastly, there is no central bank and treasury relationship that eliminates the solvency risk at the sovereign level. So, for instance, what we have in the USA is a similar system with no floating exchange rate. But the Federal government takes billions from all of the states and redistributes the funds. The states have balanced budget amendments, but the fund flow from Uncle Sam helps reduce and almost entirely eliminate the potential for a large scale bankruptcy at the state level. It’s also highly unlikely that the Federal government would even allow a state insolvency, but that’s a slightly different matter. So the big difference between Europe and the USA is that the USA is a UNITED STATES. Europe is an disjointed mix of different states. Crisis was inevitable.
So what has been done? The latest plan by the ECB is very similar to past plans. Bill Mitchell had a very excellent explanation:
“What is the ECB going to do?
The ECB will purchase short-maturity bonds (1 to 3 years) in the secondary market. Essentially, the primary bond dealer will know that they can easily off load any bond purchases in the secondary market to the ECB.
The ECB will massage their action – to make it look as though they are only undertaking the purchases to help the operations of the financial system rather than fund government deficits – by claiming that because the government debt markets are part of the overall financial market transactions their purchases will improve the monetary transmission mechanism which will, in their eyes, help support the private demand for credit.
The logic of the action is that by buying large volumes of short-term maturity bonds, the price rises and this drives down the yields. Bond traders then are forced to purchase longer maturity government bonds if they want higher yields which then drives prices up and yields down.
Lower interest rates then are considered conducive to rising private demand for credit which, in turn, will help stimulate private investment spending and kick-start growth.”
But the kicker:
“Their statement has some other significant points.
First, they are only going to purchase government bonds if the nation is already undergoing a fiscal austerity program forced on it by the Troika. The ECB say:
A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme … The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.
By which you understand that the ECB decision is in denial of the real problem – a lack of growth. They are saying that they will keep a member state alive so that it can die slowly. They know that if such a nation is forced to deal with private bond markets to gain funds to cover their budget deficit – that the Eurozone will collapse.”
This plan still fails to address the primary issue which is the lack of a rebalancing mechanism. The austerity is the antithesis of rebalancing. So while the solvency issue is being addressed by bringing private bidders back to bond markets it is almost guaranteed to be offset by the fact that these countries still aren’t going to experience growth that makes their debts sustainable. So this crisis will flare up again at some point if a permanent fix isn’t implemented. This latest “fix” buys them some time, but is really nothing more than a kick of the can.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.