Published in Business Spectator (Melbourne), 2 August 2012
While the rest of Europe was still debating fiscal solutions to the debt crisis, Mario Draghi reminded us that the answer may well be monetary. By signalling the possibility of strong ECB intervention in bond markets, the ECB president did not only calm the markets temporarily; he also revealed where the EU is heading.
It is an utterly absurd situation. Bailing out other countries (and other countries’ banks), pooling Europe’s sovereign debt or issuing Eurobonds may be incompatible with the German constitution. They may well violate EU treaty law. They lack any meaningful democratic legitimacy. They are certainly unpopular in those countries most likely to foot the bill.
In summary, the measures should be impossible to implement.
But disguised as monetary policy these quintessentially fiscal arrangements do not only become possible, they almost look legal. Simply claim that the monetary transmission mechanism is broken, and apparently there is a justification to save the whole of Europe from bankruptcy.
Even better: While fiscal measures are necessarily limited to the funds countries can raise in taxes of through running deficits, monetary interventions in a fiat money world have no such limitations. They can run for as long as tree trunks can be turned into banknotes or zeros added to electronic accounts.
But perhaps the biggest advantage in Europe’s current malaise is something else: Not a single national parliament needs to be consulted before the ECB finally opens the floodgates. No European governments need be involved in the process, and even if parliaments and governments opposed the measures they would not have any realistic chance of stopping them.
Is it any surprise, then, that German Chancellor Angela Merkel, French President Francois Hollande and Luxembourg’s Prime Minister Jean-Claude Juncker have all signalled their support for Draghi? He is doing them a huge favour because they know that European fiscal policy will ultimately fail to save Spain and Italy from bankruptcy. Europe’s politicians have neither the fiscal resources nor the political will to stop Spanish and Italian yields from spiralling out of control.
To avoid a series of sovereign defaults, this only leaves the ECB as the final backstop. But at what cost?
Let’s be clear: The trillions of euros of debt, both in the public and in the private sector, are too large to ever be repaid. Even in scenario with moderate economic growth this would be extremely difficult. In today’s Europe of economic stagnation and facing the rapid ageing of its societies this becomes an impossible task.
In any other circumstance, when borrowed funds cannot be repaid it’s a default. Not so in Europe, thanks to the help of Draghi’s ECB. By soaking up the bad debt with freshly created central bank money, Draghi will keep the illusion alive that Europe can meddle out of its debt disaster. But he can only achieve this by devaluing the savings of hundreds of millions of savers and pensioners.
Monetising debt is not a new invention. The only thing that may be unusual about Europe is the slow speed at which it will happen.
There are many commentators who believe that Europe’s debt monetisation will lead to sudden price increases. Many people then call this is inflation. This is a mistake, though.
Inflation is the blowing up of the money supply (from the Latin ‘inflare’ – to blow). What happens to prices is another matter. With the money supply being blown up or ‘inflated’, prices usually rise. But by how much and when is another matter.
If the ECB followed Draghi’s lead (assuming he was not just bluffing), a blown-up money supply would meet a sluggish environment with collapsing demand in many European economies. Under these circumstances it is not very plausible to generate big price hikes across the board.
What we will see, however, is the continuation of a pattern that has already emerged over the past few years. Prices in all sorts of asset classes will go up because that is where the smart money flees as it tries to avoid being devalued by monetary activism. Property in prime locations, vintage cars, precious metals, rare wines, paintings and sculptures – in short: everything with a limited supply – will increase in price.
We will also see the continuation of minuscule interest rates available to ordinary savers, pension funds and life insurances. They will be unable to yield a positive real return and thus leave all those invested in them poorer over time.
The general price level, what most people think is ‘inflation’, will not rise by dramatic figures. But it will increase enough to erode savings over time. Even an annual price increase of just 4 per cent is enough to halve the real value of money over 18 years. And these are the time horizons the Europeans have to think about as their problems are not only big but also persistent.
Europeans should be grateful to Signor Draghi as he has given them a glimpse into their future. It is a future in which the continent’s economic fate may be determined not by parliaments, governments, treaties or courts but by its central bank. It is a scenario in which every owner of money will be robbed a little each year to pay the debts of sovereigns and the financial sector. And it is a Europe in which the smart money of the rich and mobile may escape the worst but leave the former middle classes struggling and impoverished.
In a way, this is the best that Europe can still hope for in its current mess. No wonder the markets were celebrating.