European Central Bank Holds the Key to Resolving the European Sovereign Debt Crisis

This will be a short post, but I wanted to update my recent post about the European sovereign debt crisis.  Everything in that post that I wrote I still hold to be self-evident truths.  If anything the situation in Europe is worse now than when I wrote the post.  Here’s what I have to add now:

• Beyond the Euro-negotiators not addressing the underlying causes of their misery, the next biggest problem is differing focus on time scales.  Huh?  What does that mean?  It means that the investment markets around the world appreciate an intra-day/intra-moment timescale.  Whereas, the politicians trying to resolve the European sovereign debt crisis have an intra-decade time scale.  This differing appreciation for time only serves to exacerbate the crisis.
• It’s my feeling that we are down to one power source that has the power to resolve the crisis: the European Central Bank (ECB).  Because of the gigantic Gordian knot of a problem in Europe only those power sources that stand outside of the system can affect an outcome.  The International Monetary Fund is another such party, but they have already committed inordinate resources to help resolve the European sovereign debt crisis.  That leaves the ECB as a last resort.

Why is it that it is highly likely that the ECB, and only the ECB, can resolve the crisis?

• The sovereign debts in Europe far exceed any of the European nations’ ability to grow themselves out of the problem.  In other words, debt balances are growing faster than the economy.  To reverse that trend, governments would have to run very, very large government surpluses from tax revenues harvested from a growing economy or growing tax rates.  Unfortunately, Europe already has high tax rates and historically put-put growth.  So this looks to be an unlikely scenario.  However, the ECB can print money.  That excess of money chasing the same set of goods will drive up prices and create inflation.  That cheapening of money makes the debt cheaper to refinance as it comes due.  Unfortunately, to do this, the ECB would have to break the law as it is expressly forbidden that the ECB inflate the money supply of the Eurozone.  So this solution – a highly potent and easy one – requires a change to European law and philosophy.
• Another version of printing money, and one that the ECB has been engaging in – is to be the bidder and buyer of last resort in European sovereign debt markets.  All open financial markets are auction markets.  What happens on eBay when no one bids on an item?  That’s right, it doesn’t sell.  A smart seller would lower her price in such a situation in order to transact.  This is exactly the scenario taking place in Europe right now.  Well almost.  The ECB is buying European sovereign debts.  Thus, the ECB is providing bids in the auction and in many cases I am guessing they are the only buyer.  This action is maintaining some semblance of price stability so that European sovereign debt prices don’t collapse/European sovereign yields rise to crazy levels.  When the prices on debt fall, but the interest paid remains the same, then the yield increases.  Why is this important?  It is important because most governments around the world do not pay off their debt.  Instead they refinance it.  Governments, just like businesses and people, are forced to refinance at the going yield.  So if the yield is astronomical then they just increase their needs for more debt in order to pay increased interest.  Think about nearly bankrupt consumers who use a lower rate credit card to pay off a higher rate card.  This works until the rates get higher.  Then their credit/refinancing needs actually grow and it becomes a spiral toward bankruptcy.

To my worldview, it looks like this whole (almost) catastrophic situation is down to just the ECB.  Sans the ECB, we are very near the kind of perfect storm whose outcomes are very difficult to predict.  What’s more those outcomes are varying degrees of bad, with not much good in them on the short to medium time scale.  On the long time horizon a catastrophe has the ability of changing the behavior of how governments around the world budget themselves.  To get there is like withdrawal for an addict – not pretty.

Jason