Thursday, June 28, 2012

The ECB can easily save the eurozone

As a thought-experiment, let’s imagine that Germany decides to permit (or is forced to permit) a monetary rescue of the eurozone, as opposed to a fiscal (eurobond) approach.

There is a rate of inflation (perhaps 8-10%?) that will allow the PIIGS’s to close their budget gaps, as nominal revenues race ahead of expense. So the PIIGS will be in surplus and their debt/GDP ratios will start to decline. Additionally, the euro will weaken in the foreign exchange markets, which will improve the current account positions of the PIIGS as well. That’s a pretty good start.

Let’s also say that the ECB stands ready to refinance the maturing debt of eurozone members based upon certain fiscal criteria and at various risk-adjusted interest rates (which are lower than current market rates). This will expand the ECB’s balance sheet, perhaps at the desired rate or perhaps above it. To the extent that the ECB’s asset growth exceeds the targeted rate of inflation, it can sterilize its purchases by selling “ECB bonds” to the public (just as the Fed can sterilize purchases of agency MBS by selling Treasuries). Investors replace their risky government bonds with “riskless” ECB bonds (riskless, because the ECB prints euros).

This would mean that not only would the PIIGS be in surplus with declining debt ratios, but also that they would no longer face refinancing risk. Crisis over. And not only would Germany not have to bail out anyone, it’s own creditworthiness would improve as well (at the expense of its credulous bondholders).

Frankly, I can’t imagine a better outcome for all. Europe would immediately enjoy nominal growth, followed by real growth as confidence and investment return. Just as inflation is always and everywhere a monetary phenomenon, so is nominal growth. If the Bank of Italy can manage it, so can the ECB.

The costs of this strategy are that price stability is sacrificed for growth, and holders of low-yielding euro-denominated bonds will suffer. The sacred “credibility of the euro”, so near and dear to the Germans, will be shattered forever. It might even become, temporarily, a “high yield currency”. A weak euro with volatile inflation will theoretically raise the risk-free real rate of interest in the eurozone.

But why do modern central banks exist? Don’t the reasons include (1) preventing financial collapse, and (2) preventing depressions? If so, Germany will have to discard the “hard euro” shibboleth, and accept what the US has already done, which is dual mandates of low inflation plus growth. Hyperinflation is an extremely destructive and inequitable event, but that is not what is recommended. What is recommended is inflation such as the world experienced in the 1970s, which did not end Western civilization.

Everything that I have written above is already in Mario Draghi’s mind. The problem is that it will take much more dislocation and distress to force Germany to permit the ECB to “go wild”. They are wedded to the hard euro and to the single mandate. So in the end they will have to choose between a Mediterranean monetary policy or a Mediterranean economic collapse. Please pick one.

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