The game-changing aspect of the eurozone member states’ plan to stabilize the euro is not the $139 billion Greek bailout or the trillion-dollar currency stabilization fund per se, but rather the about-face of the European Central Bank, which will now reverse a longstanding policy and purchase the debt of euro states. In doing so, the ECB and its president Jean-Claude Trichet, have opened the door the the monetization of euro sovereign debt, which is to say the effective real default implied by inflation and currency debasement.
In essence, the ECB can now create euros to buy Greek or other European debt, including cross-eurozone bonds issued to finance the euro stabilization war-chest. Since that fund could borrow to support the euro and the ECB can purchase that debt as well as the bonds of individual euro nations, the net effect is to allow the assumption of a distressed member state’s debt by the entire euro membership and the inflating away of that debt through euro creation on the part of the ECB.
If all this sounds familiar to American ears, it should, since the power to monetize dollar-denominated debt has long been possessed by the central bank of the “dollar zone,” that being of course the Federal Reserve. Indeed, most central banks around the world have the ability to inflate away debt denominated in the currencies they create. A crucial difference between the ECB and its brethren has been that sovereign borrowing in the currency over which it presides has been done by sixteen individual states, and that debt has until now been off limits for purchase and thus monetization. The analogous situation in the U.S. would be if all government borrowing were done by the individual states through municipal bonds.
Now, monetization with its attendant inflation and devaluation is indeed a form of default, since in real terms debt holders are paid back in money which will now buy less goods, services and foreign currency than it did when it was lent. Yet even if bondholders are burnt in terms of purchasing power , there are certain systemic advantages of real default over the nominal variety, in which lenders are paid only a fraction of the currency (euros, for example) which they are owed.
Consider banks borrowing from depositors in euros and lending to eurozone governments by buying their bonds. In a nominal sovereign default, the bank might not have enough euros to pay back its depositors, which is the kind of thing that tends to lead to bank runs. But in a monetization-driven real default, the bank gets paid in full and so do the depositors, albeit in a debased currency. Banks’ and depositors’ euros might not be worth much but they get each and every one they are owed. Financial institutions’ balance sheets may shrivel in real value but they continue to balance, avoiding runs and some types of systemic shocks.
Similarly, and rather paradoxically, the certainty of nominal payment under real default has at least one “operational” advantage in the creation of the reserve currency the eurozone members would like their currency to become: knowing the ECB can print euros to pay off euro debt, the world’s central banks can invest the currency in assets whose nominal return can be calculated with more certainty, as can future holdings of the currency itself. Again, the future value of that currency may be in question but not the amount of it to be received.
The balance sheet stabilizing aspects of real default can come at a high price, including the destruction of savings’ buying power, growth-killing price uncertainty and, as demonstrated in the Europe of the 1930’s, social unrest and war (this has something to do with the reticence of Germany in regard to the euro rescue, as evinced recently in the Westphalia vote). Inflating away debt is a treatment best administered sparingly, if at all. How much tolerance electorates of more solvent euro nations have for being taxed to pay the bills of their less productive, more profligate neighbors may well end up the determining factor for the euro’s survival, at least in its current form.
One silver lining for the Europeans (at current prices a golden one would be too much to ask for): with both the U.S. and Japan up to their eyeballs in government borrowing, the real default risks of dollar, euro and yen sovereign debt could at least partially negate each other in a rough balance of fiscal and monetary irresponsibility. And if these currencies’ mutual risk of debasement puts more pressure on China to revalue the yuan, I can almost hear a chorus of finance minsters singing hallelujah.
It’s worth mentioning that, in the wake of the Fed’s recent broad-spectrum asset purchase programs, we may yet see the day munis are added to that central bank’s balance sheet. After all, even a casual observer of the disconnect between California’s entitlement-driven spending and any realistic projection of its tax revenues could be forgiven for viewing Athens as simply Sacramento on the Aegean.
Addendum: Those of you who enjoyed my rather skeptical remarks on the role of swaps in the Greek crisis (“Greece And The Zen Of Credit Default Swaps”) may also enjoy a similarly-minded piece by Stefan Schultz in Der Spiegel, in which I’m quoted extensively. One caveat: it’s much more enjoyable if you happen to read German; if not, should you paste it into a translator program, note the amusing fact that Trester is the German word for wines otherwise known as marc or grappa, which is how my surname may be automatically translated.