Jeff Harding

The Eurozone Debacle: They Ate The Golden Goose

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The European Central Bank is taking emergency steps to prop up eurozone banks by opening the money machine to member banks and by resuming the monetization of sovereign debt of weak economies. Bond vigilantes are targeting Spain and Italy, rightly so, as the condition of their banks and sovereign fiscal problems are dragging down their economies.

The problem is not unfamiliar to Americans. The difference is that the eurozone is a completely unworkable system; rules requiring fiscal prudence of its members are generally ignored whenever it suits those governments. Think of their system as if the U.S. had no federal government but did have the Fed. When Illinois or California go down, the Fed would intervene to prop up their banks and state bonds in order to prevent the panic from spreading to other states. That might make productive states like Texas a little resentful. Substitute Spain and Italy for Illinois and California, and Germany for Texas and you get the idea.

The problem with Italy and Spain is that they are seriously socialist-welfare states with strong unions and difficult labor policies making it difficult for businesses to expand and be productive. They too are saddled with huge social security and Medicare-type obligations which cannot be maintained. They also have substantial debt:

Graph depicting EU debt as percentage of GDP 2011-2012

The other problem they have is substantial near-term debt rollover funding needs:

Graph depicting EU Sovereign Funding Needs

Both Italy and Spain are finding it difficult to raise money from the markets right now because their borrowing costs have skyrocketed. The Bund spread, the difference between Germany’s 10 year note and Italy’s is 3.66%, about double from a month ago. Ditto for Spain.

That aside, European banks are having trouble obtaining financing in the overnight markets, i.e., dollars used for the repo market, a market that banks usually lend to each other on an overnight basis. They haven’t been able to float bonds that would give them more secure longer-term financing. And they are very worried about the soundness of all that sovereign paper they hold:

Graph depicting banks' exposure to eurozone debt

As a result of all this exposure, banks are holding on to dollars in order to bolster their liquidity requirements in the event of a credit freeze. They are also doing what they can to reduce their exposure to sovereign debt by selling it or buying CDS insurance on the debt they hold.

As a result the dollar market has become very tight and banks are relying on the ECB for short-term funding:

Many European banks have responded to the latest difficulties by hoarding cash. In one proxy of bank anxiety, banks are stashing money at the European Central Bank’s ultrasafe but low-interest-rate overnight deposit facility, effectively taking funds out of the banking system. Nearly €105 billion ($149 billion) was parked at the facility on Tuesday, the highest level since February, compared with €86.6 billion a day earlier.

At the same time, banks appear to rely more and more on the ECB for short-term funds, another signs of stress.

The ECB’s one-week refinancing facility saw borrowings rise to €172 billion from €164 billion. While the increase might seem small, it is significant because at this time of the month demand for borrowings generally would decline…

The U.S. branches of foreign banks have nearly tripled their dollar holdings, from $374 billion at the beginning of the year to more than $1 trillion in late July.

Eurozone money supply has been flattening out for some time, reflecting the decline of liquidity in their economy.

So the ECB announced today that it would step in and create as much money as the banks needed:

ECB President Jean-Claude Trichet said at a monthly news conference that the bank would offer a six-month tender of unlimited size next week. That means banks will have the opportunity to borrow as much as they want—against appropriate collateral—for six months, ensuring they will stay liquid even if shut out of wholesale funding markets.

At the same time, traders reported, the ECB reopened its program of government bond buying for the first time in five months.

Mr. Trichet didn’t directly confirm the government-bond purchases. However, he repeated that the Securities Markets Program is “ongoing” and that “you will see what we are doing.”

Under the SMP, the bank buys euro-zone sovereign bonds in order to ensure that the market is functioning smoothly.

As Mr. Trichet spoke, traders in London reported that the ECB was buying Irish and Portuguese government bonds, in what would be the first such intervention since March. Several traders said the purchases were small. Two said they estimated the total amount purchased at €300 million ($429 million).

If things get really tight, there is always the swap arrangement between the Fed and the ECB whereby the Fed will supply them with as many dollars as they need. This was done in 2008 and 2009.

The problem is that the eurozone is heading into recession or stagnation and there is no way they can easily inflate their way out of the problem or rely on increased tax revenues.

There is no secret formula to “fix” what is wrong. Mr. Trichet and many others have been hammering at these governments for the need to reduce debt, reduce spending, and liberalize their economies to spur economic growth. Economic growth is the only thing that can save these countries. As well as monetary reform, of course. Without economic growth everything else is just window dressing. Then again we in the U.S. have the same problem.

Most of these countries have run up debt that they cannot possibly repay and there are only two ways to deal with it: inflate it away or repudiate it. Inflation is probably not an option for the eurozone. By raising taxes and cutting spending, they will only temporarily stave off the problem. While cutting spending is good, what they need is lower taxes and liberalized economies to allow businesses to do their thing. After all the only source of revenue any government has is taxation and only business profits can provide that. What these advanced socialist economies are discovering is that you can kill the goose that lays golden eggs.

It is apparent that some of these PIIGS will default, maybe all of them.

Copyright © 2011 · The Daily Capitalist

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Published by kind permission of Jeff Harding.
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