November 29, 2011

YEAH, BUT THEY'VE SOLVED THAT POPULATION GROWTH PROBLEM:

The Euro Area Is Coming to an End (Peter Boone and Simon Johnson, 11/28/11, Bloomberg)

The French, along with U.S. and U.K. officials, are pleading with the European Central Bank to come to the rescue. Their hope is that the ECB can remove credit risk by promising to back all sovereign and bank credits in the euro zone. This is what politicians mean when they say "bring out the bazooka."

When large amounts of any currency are printed in response to deep structural flaws, it's hard to trust that money. A massive bond-purchase program by the ECB would reduce credit risk but increase the danger that the euro will decline in value against the dollar and other currencies. And if the ECB needs to continue buying more debt to finance deficits and prevent defaults -- because peripheral countries could stop making painful fiscal adjustments once the ECB starts buying bonds -- wages and prices would increase, as we saw in the U.S. in the 1970s. This is anathema to the Germans.

We would soon see German bonds sold off as investors protect themselves from long-term inflation, which erodes the value of such debt. People holding bonds with a high credit risk (such as Italy and Spain) would surely sell many of those to the ECB, or simply cash out when those bonds mature in case the central bank, at some point, stops buying.

An ECB "bazooka" wouldn't restore competitiveness to Europe's periphery, so even with this, Europe's troubled nations would require many more years of tough austerity and budget reform to stabilize debt.

This would all just look like another unsustainable debt profile. Germany would be paying higher interest rates on its debt, while most banks and the periphery would be heavily financed by the ECB -- and both credit and currency risk premiums would remain. Markets would eventually turn against Europe with a vengeance, and with no more plausible solutions, the whole system would come tumbling down amid both inflation and debt restructuring. 
Posted by Orrin Judd at November 29, 2011 6:17 AM
  
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