It should be clear to everyone that the only way to save the Euro is to issue unlimited funds to back up Greek and Italian debt.  That debt has to be restructured one way or another, as with rational growth forecasts neither country will generate enough revenue growth to keep up with the interest on their debt.

One way to restructure is to inflate that debt away, and the ECB can do that by printing Euros.  But a problem looms — the ECB is not a sovereign bank and needs the support of Euro member nations.  And Germany — happy, complacent Germany, which feels it has done everything right, and whose only concern is to avoid under any circumstances risks of significant inflation — won’t agree.

This is becoming an “Irrestible Force meets an Immovable Object” problem.  The force is the rising interest rates of Euro member countries; and the immovable object is the refusal of Germany to allow the ECB to print the euros needed to deal with this.

Of course, there is no longer any painless way to resolve these problems.  As we have long predicted here, every effort to put off dealing with the Euro debt problems has made it harder, not easier, to resolve the problems and will increase the pain involved.

If Italy’s fiscal situation cannot be improved, bond speculators will turn to Spain, and then France.  And they can do so without fear, because their bond holdings are probably insured with Credit Default Swaps, so they get paid (by whom?) if there is a default.

We saw exactly this problem in the US with Lehman in 2008 — with people holding CDS, there is an incentive to drive firms into bankruptcy since you can make money from their failure by buying CDS and then selling short; you make money on the way down and then get more money back when the firm goes under.  As some market observers said, it was like buying fire insurance on homes in other neighborhoods — if they burn down, it’s not your house that you lose, but you get paid handsomely.  So the incentive is to encourage the fire.

These CDS should never have been allowed or should have been tightly regulated.  They are in fact no more than promises that no one expected to have to make good.  So bank A can pay bank B a fee to issue a CDS against, say Italy.  In return, Bank A gets a piece of paper saying bank B will pay off any losses from holding Italian bonds.  That means Bank A now has a “risk free” asset that it can use as a core capital holding, allowing it to take much riskier and more lucrative bets with other capital.  Meanwhile, Bank B pockets the fee and parts with a piece of paper that it estimates it will never have to pay off because the EU will never let Italy default.

But what happens? Bank A has taken risky bets that it feels are balanced by its CDS guarantee on its Italian bonds.  Bank B has a liability that it has no resources to fund if Italy really should default.  Now Italy announced it may not be able to pay its debts without a rescue.  Who is in trouble?  Is it bank A who becomes insolvent if its risk-free bonds turn out to causes losses on top of the riskier parts of its holdings?  Or is it bank B who becomes involvent because it can’t pay out on its CDS?  Who gets bailed out?

In the US, AIG was “bank B” and got bailed out to the tune of hundred of billions of dollars; that saved the “banks A’s” including Goldman Sachs and others who got their CDS honored.   But the US had to borrow about $1 trillion to save the banking system as a whole.

Europe now faces the same situation with sovereign and bank debt that the US faced with mortgage and bank debt.  Billions of dollars in ‘risk free’ assets turn out to be facing default.  The Eurozone countries, meaning mainly Germany, will have to borrow money to save the system; and it may get wracked by serious crisis anyway before that happens.  It will have to be done sooner or later, so PRINT EUROS.  NOW.

About jackgoldstone

Hazel Professor of Public Policy at George Mason University
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1 Response to PRINT EUROS!

  1. Tony T says:

    Jack, I think you’re right on the money. It’s make-or-break time (once again) for Europe as the death spiral begins to pick up steam. Rising bond yields in relatively stable countries like France and today’s weak German bund sale is yet another shot across the bow.

    Ms. Merkel and other conservatives are correct—Euro Bonds are going to be painful, for everyone. The German people are going to have pay, risking throwing good money after bad as the Euro Bond moral hazard risks creating more profligate spending. The troubled countries are going to pay, too. These countries are going to be subject to harsh oversight or what the European Commissioner for Monetary Affairs called “fiscal surveillance and policy coordination.” I would call it a serious affront to sovereignty.

    Ms. Merkel is wrong on one thing. The Euro Bond IS the solution–and right now. The longer Germany waits trying to hash out the details to make sure Germany is protected from risk, the faster the lack-of-confidence contagion is going to attack the system.

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