According to Karl-Otto Poehl, the head of Germany’s central bank from 1980 to 1991, the foundation of Europe’s single currency has suddenly changed. In an interview with Spiegel magazine, Poehl says that “in the treaties governing the functioning of the European Union, it explicitly states that no country is liable for the debts of any other. But what we are doing right now is exactly that. Added to this is the fact that, against all its vows, and against an explicit ban within its own constitution, the European Central Bank (ECB) has become involved in financing states.”
In theory, inflation should be the outcome of this new policy of bailouts. A blog on FT Alphaville earlier today suggests that the European Central Bank may be involved in an attempt to weaken its previously stated commitment to “sterilise” its buying of European government bonds under the new intervention policy (whereby it removes liquidity from the money markets to the same extent that it is adding cash by purchasing Eurozone bonds). If so, that’s a clear loosening of policy.
The blog’s author, Tracy Alloway, notes that the one week deposits the ECB is using to soak up money market liquidity can, in turn, be used to obtain financing under the ECB’s “Long-Term Financing Operation” (LTRO). “What liquidity the ECB takes away with one hand, via the term deposits, it gives in unlimited amounts with the other,” she writes.
On the other hand, in a research report (“The Limits of Debt”) published yesterday, Andrew Smithers argues that “debt in both the private and public sectors appears to be reaching the limits of market tolerance.” Furthermore, writes Smithers, “as we reach the limits of credibility for sovereign debt, we must aim for a way to reduce private sector debt other than by switching it to the public sector.”
According to Smithers, if public debt levels are hitting their limits, as seems evident from recent market behaviour, then this implies that the decades-long policy of the public purse underwriting private sector debts, particularly evident in the banking sector, will have to end. Corporate default levels, which have been artificially depressed by government intervention, will rise sharply, and the likely trend towards reducing budget deficits will aggravate this trend towards default, since the household and corporate sectors can expect a worsening in their cash flow.
“Rising private sector bankruptcies are likely and needed to constrain debt growth in the future. They will, however, also tend to constrain growth and be negative for both equity and corporate bond markets,” concludes Smithers.
Contracting demand, rising defaults, worsening corporate cash flow: these, clearly articulated by Smithers, are the deflationary outcomes of the current economic predicament. He finishes, however, with a caveat: “If the moral hazard issue is not faced and governments continue to bail out the private sector, the result will be inflation.”
Which way things now go is anyone’s guess. Although Europe’s monetary authorities have cranked up the printing presses, a legal challenge in Germany to the Greek bailout rumbles on in the constitutional court. Meanwhile, according to Ambrose Evans-Pritchard in today’s Daily Telegraph, the US Senate has intervened in the debate by adding an amendment to the financial reform bill to block the use of US taxpayers’ money in IMF rescues where the debtor country concerned is in too poor a shape. Though this amendment may not pass, the fact that it has been added to the bill may be a sign of a change in the wind.
The “moral hazard trade”, as Felix Salmon of Reuters yesterday described the assumption that governments will always step in to prop up asset prices, may be coming to an end. “Governments have much less ammunition now than they did pre-crisis, even if they still have the willpower to intervene to save markets from themselves. And the willpower is evaporating rapidly, to boot,” argues Salmon.
So while inflation may seem like the obvious outcome of the latest huge bailout, don’t bank on it.