A funny thing happened on the way to the office today; I helped save the EU banks. You did, too. As well as Canada, England, Japan and the Swiss (if needed).
In the event that you happened to sleep through the entire morning, here’s the lowdown on what happened (or is it DL? It’s tough to get older): At 8 o’clock this morning EST, the announcement came out that our own Federal Reserve, in conjunction with the Bank of Canada, Bank of England, Bank of Japan and the Swiss National Bank agreed to lower what’s essentially the borrowing costs of obtaining dollars to help backstop those European banks that are struggling. To see how the equity markets have rallied off of this news, you’d think the Fed was giving the money away, but in reality all they did was cut the borrowing rate from 100 basis points (1%) to 50 basis points (.5%). The perception is that those Euro banks now have the backing of another source of funding, since the European Central Bank (ECB) cannot print money, due to its charter language. All this was apparently enough to send U.S. equity prices off the launching pad, with both the Dow and S&P up approximately 3.5% on the news at midday. But I’m getting a bit ahead of myself; as you might expect, this action raises a boatload of questions and demands analysis. So let’s take a closer look, since unintended consequences usually get pushed aside when there’s money to be made (did I say that out loud?).
First off, let’s address why this action happened in the first place. Major European banks are awash in sovereign debt (government debt), as well as a host of bad loans generated during the boom years of the global economy. There’s an old saying that things can continue to merrily hum along as normal, until they don’t. It happens in family budgets, municipalities and governments. As long as the income stream flows consistently, all can be paid for and all is right with the world. But when there’s a slip and a stumble (job loss, lower taxes, ie: recession), things can go sour quickly, which is, of course what has happened over the past few years. Therefore, banks hold bad loans, governments (Greece, Portugal, now Italy) have difficulty paying on the promises they’ve made to the general public and they have trouble financing their debt. Since it’s the banks that hold much of this bad debt, they are the ones on the hook if/when these loans and bonds go south, meaning they have to write off the debt as losses. They know this; which is why initially they start to constrict their lending (to keep more cash on hand), as well as to borrow more in the “interbank” market, which is where they can borrow global currencies.
If they continue to feel uncomfortable with the economy in general AND they feel the odds are increasing that the debt on their books may be uncollectable, they will not only further constrict consumer lending, but also lending to each other begins to slow. Basically, they begin to hoard cash as their own backstop against deteriorating loans. Another problem is that lending on the interbank market becomes more expensive. Recently the interlending rate between European banks reached a three year high, which meant the cost of borrowing money on the open market was becoming very expensive. At this point the EU has to assess its options; does it “print” euros to increase the flow of money to prevent a liquidity freeze (think TARP), does it let some of the banks fail or do they reach out to the international community for help?
Obviously, we now know the answer and this is where it gets interesting. Remember in “Hope As An Option”, I stated that the ECB does NOT have the capability to “print” euros, since the EU (European Union) charter forbids it. Why? Remember again that Germany (and France) had considerable influence on the drafting of the charter and what the ECB currently decides. Germany remembers all too well the disastrous effects of hyperinflation during the Weimar Republic after WWI (attached below is a PBS link detailing hyperinflation during the Weimar Republic) and is none too thrilled with reliving those years in which their currency (the mark) was virtually worthless. http://www.pbs.org/wgbh/commandingheights/shared/minitext/ess_germanhyperinflation.html
This is why AT PRESENT the ECB does not print to fund its member banks with euros; in order to do so, it would require Germany’s approval to alter the EU charter to allow it. This is very unlikely UNLESS there is a game-changing moment in which printing is the lesser pain versus allowing some EU countries to fail, which is always led by the banks failing first. That is why today’s action of lowering the borrowing cost (and increasing availability) of dollars is being hailed as a solution; no perceived future euro hyperinflation and the banks receive needed capital. As long as it works, euro printing will not be an option.
As an aside, let’s clarify what “printing” means in this context. When the U.S. “prints” dollars through quantitative easing, Ben Bernanke isn’t actually directing the GPO (Goverment Printing Office) to print more paper money. Rather, he’s instructing the Federal Reserve to buy debt from the Treasury and open market (banks) and adding to the Fed’s balance sheet. It’s really an accounting maneuver which transfers dollars from one entity to another. Since the dollars go only one way, it’s as if the goverment is adding or “printing” dollars to pay for that purchased debt. However, if the Fed buys debt, but at the same time sells debt they already own, it’s revenue neutral, meaning nothing is net added or “printed”. This is what “Operation Twist” is about. Regardless, the eventual effects of the added or “printed” money will be felt in time, as if it actually was paper money being exchanged.
What is bothersome however, is the rapidity and suddenness of the global central banks’ agreement this morning. One has to wonder just how close to freezing the credit lines of the European banks actually were and if there was any time left to debate the merits of euro printing (not to mention the coordination of voting to alter the EU charter to do so!). It’s quite apparent the equity markets were completely taken by surprise, since the U.S. equity futures were only moderately higher prior to the announcement. This truly was a European “bazooka” approach, although as in most quickly implemented plans, there will be unintended consequences.
One of those consequences (unintended or not) is currently on display as I write; that of the U.S. equity markets rising stratospherically. With U.S. dollars in place to act as a backstop to EU banks, both the Dow and S&P 500 are up approximately 3.5%. The reason is fairly transparent; if the risk of European banks failing has lowered dramatically, then two things may very well occur: most importantly, the risk of a European recession has been lowered significantly due to increased liquidity; secondly, the confidence of knowing that the banks will continue to be there to lend, thereby continuing consumption and finally, the perception that asset prices will inevitably rise as that consumption resumes. There are however, unintended consequences involved that are as of yet, not being discussed.
Since it’s the dollar that’s being borrowed and put into circulation, that in and of itself is inflationary, if not immediately, then in due time. For example, if the Fed (or the interbank) is holding dollars, but now is lending them to EU banks, that money will initially find its way into bank vaults as a backstop and/or to be used as credit lines. Additionally, if the cost of borrowing dollars has fallen, borrowing demand for those dollars will probably increase, thereby potentially increasing the Fed’s balance sheet. The question is, will the Fed deem it necessary to do so? Eventually, however, those dollars will find their way into commerce as a result of loans from banks to individuals/corporations, which in turn will spend that money in the economy. Since as a general rule, the more of anything reduces its value, the more dollars in the global economy that are present, the less its value will eventually be. If the value of the dollar falls, then it stands to reason that it takes more of them purchase the same goods and services than it did before, thereby making it feel as if prices have risen. The argument can be made that the U.S. has potential inflation problems of its own making due to TARP and QE2, but the addition of extended, easy credit on a global basis may exacerbate the problem by flooding additional dollars into the global economy, thereby fueling dramatic increases in inflation. Granted, it won’t happen immediately, but it will happen if left unchecked. Normally, when price inflation is caused when too many dollars chasing too few goods brought upon by a strong economy, the solution is to increase interest rates to cool demand. However, when price inflation is caused by a devalued currency in an economy in which jobs are not being created, that same strategy can be catastrophic. Easy credit to the eurozone may not be the appropriate solution.
There can be other problems on the horizon due to too many dollars in circulation. If the dollar is being used to backstop EU banks and if the EU finds this course of action preferable to printing euros, the opposite of the dollar falling in value would be for the euro to maintain or perhaps increase, its current strength. This has implications for trade. Since the eurozone is dependent on exports (especially the southern zone), a strong euro will keep European goods expensive relative to the dollar. This means that if the dollar falls and the euro stabilizes or increases in value, the same European goods being exported to the U.S. will be more expensive. This had two negative effects: first, the very same European countries that need to export to rebuild their economies will be charging more for their goods and may experience an additional slowdown because of it. Additionally, with austerity measures being voted on in the EU, government spending in conjunction with slower sales could prove to be a “double whammy” for Europe.
Secondly, U.S. importers would feel the pinch, as their sales would lag, which in turn may slow down that sector of the U.S. economy. This, in conjunction with decreased government spending cuts and mediocre jobs creation, could further be a drag on the economy and very well might be the catalyst for another recession. The bright side would be that U.S. exports would in turn be cheaper, thereby potentially increasing sales overseas, should those markets’ demand pick up. In this scenario, a combination of higher priced imports and cheaper exports could result in a new “buy American” campaign, in which Americans purchase more domestically made products. The downside, however, is that in that type of environment, protectionist measures (tariffs) usually are the result, followed by retaliation. Wars have started because of such measures, but that is for another post.
As if all that’s happened today isn’t enough, last week the US “Super Committee” failed to agree on $1.2 trillion of budget cuts over ten years. Just another example of “punting” the problem down the road. Why make the hard decisions and risk election fodder when you can wait until after the election? While their outcome itself isn’t too surprising, it will be surprising to see just what the “mandatory” cuts that will be in put in place will be.
One thing is certain; we’re all in this together. Thank you for reading!
DB
