The euro area risks 'hyperdeflation' and, ultimately, demise


ECONOMICS: The European Central Bank must intervene in the government bond market to prevent a default by solvent states such as Spain

CONFIDENCE IS crucial in economic and financial affairs. Once it is lost, it can be very difficult to rebuild. Confidence in the euro zone is draining away and matters have gone so far that it is not at all certain that any set of measures will stop the slide.

How much of the inaction and delay is brinkmanship by some creditor countries to ensure debtor countries impose reforms they need remains to be seen. But the price of brinkmanship is paid in confidence and credibility.

The most recent decision of the European Central Bank to further erode its own credibility came last Friday when it signalled that its interventions in the sovereign bond market would be limited to €20 billion a week. It is hard to imagine a worse decision. Self- declared ceilings on purchases guarantee the ineffectiveness of intervention.

That was all too plain to see this week. On Tuesday the Spanish treasury was obliged to offer interest rates of 5.1 per cent on bonds maturing in just three months. That was more than double the rate (of 2.3 per cent) it offered on the same securities just one month ago. This can only be explained by a massive panic premium. Spanish government debt is lower than Germany’s and the effectiveness of that country’s political system is closer to Germany than Greece.

On Wednesday, the outright failure of Germany – of all countries – to sell all the bonds it had put up for auction gave a further sign of just how fragile the situation has become.

Without the biggest change of policy tack yet, Italy and Spain are unlikely to be able to raise money at any price within months, if not weeks. Such a scenario would leave these countries unable to pay maturing debt. Without an emergency bailout, a second and third euro zone sovereign default would take place. In the short term, the ECB is the only institution with the wherewithal to prevent the situation reaching that point.

If evidence of the power of open-ended central bank commitments is needed, Europeans have only to look inwards to see it. Switzerland, surrounded by euro zone states, is a perceived safe haven. It experienced very sharp exchange rate appreciation during the summer and into the autumn as a result of capital fleeing the euro and flooding into the Swiss franc. The soaring franc threatened to price the Alpine economy’s exports out of international markets.

When the Swiss National Bank (SNB) responded, it came out with all guns blazing. The response was almost instantly effective, bringing down the value of the franc and anchoring it at or close to the level it had targeted against the euro.

The SNB was successful because it has an unlimited supply of Swiss francs to sell. Once it signalled that it would exercise this option as aggressively as was necessary in order to prevent its currency rising above a named threshold, the euro, franc exchange rates stabilised. And the lesson: market participants know they cannot win against a central bank with unlimited firepower.

For those wondering why the Irish Central Bank was not able to prevent the Irish pound suffering devaluations in the past, it should be recalled that to support a weakening currency you need to buy your own currency. That requires foreign currency. Because central banks have a finite supply of foreign currency, their reserves will be depleted sooner or later if the markets push them far enough. But markets cannot defeat a bank selling the currency it prints for itself.

The ECB must intervene now in the government bond market with the same determination that its Swiss counterpart has done in the foreign exchange market.

This, of course, does not mean there is a free lunch available. It is intuitive to anyone that, for one branch of government to lend to another, is not a costless means of solving the underlying problem of public overindebtedness. But that is not the purpose.

The purpose of intervention now is to eradicate the panic premium that could push a government as solvent as that of Spain’s into default within weeks.

What are the objections to taking such a course of action? First, if the ECB bails out bad governments, it provides an incentive to all to govern badly. This is moral hazard. But the ECB put moral hazard to one side after the collapse of Lehman Brothers in order to save the financial system. It must do so again to prevent sovereign default. It could be added that the departure of George Papandreou and Silvio Berlusconi goes a distance to addressing the moral hazard problem anyway.

Another argument against the ECB buying up large amounts of government debt is that it will cause inflation. But a central bank can “sterilise” its bond purchases by conducting counterveiling operations so that the money supply is not affected. That is exactly what the ECB has done. I cannot see any reason why there should be a limit to the amounts it can sterlise.

And even if some or all of the purchases were not sterilised, there is little reason to fear inflation running out of control in the prevailing economic climate. Just look at Britain and the United States. In both countries unsterlised central bank interventions have been conducted in the form of quantitative easing (QE). But even with these large unsterilised interventions, inflation in both economies is only slightly ahead of the rate in the euro zone.

There is plenty of scope for the ECB to follow the lead of other central banks without any danger of inflation, never mind hyperinflation, a spectre raised by the ECB’s ultra-orthodox Jürgen Stark in Dublin on Monday. It is true that if unsterilised central bank intervention is done to excess and for too long it will certainly destroy a currency, as periods of hyperinflation in Weimar Germany and today’s Zimbabwe have shown. But Europe is light years from that point.

Yet another concern that has been raised about purchasing government bonds is the risk of losses for the ECB if the bonds it is exposed to are written down.

Treaty law appears to rule out the bank printing money to give to governments to pay off their debts (known as monetisation). If that is so, the question becomes how big a loss could the Frankfurt bank take before becoming insolvent itself?

Opinions differ on how much capital the ECB and the wider euro system of national central banks has. But the choice facing the bank is between risking some of its independence (by seeking recapitalisation if it does burn through all its capital) and putting its own existence at risk.

Europe is now very close to a default on Italian or Spanish debt. That would, in turn, trigger a collapse across other asset classes. It is hard to see where this would end until all the dominoes had fallen.

Therefore, the imminent risk Europe faces is – to coin a phrase – hyperdeflation in asset prices, not hyperinflation in consumer prices. Everything possible must be done to prevent hyperdeflation. If the ECB does not act to prevent that, it will surely bring about its own demise.

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