Edward Harrison of Credit Writedowns made a very interesting post…
Monetisation, default and breakup
…As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout. On the other hand, it could be a possibility for Spain because Spain is simply too large to bail out in the way that Greece and Ireland were bailed out.
As I mentioned, Greece is clearly not making the grade and will be unable to lower its debt to GDP through internal devaluation and austerity without serious growth via exports and currency depreciation. There are almost no circumstances in which all of these positive factors can come together. Ireland, on the other hand, despite having socialised its banks losses like Iceland, is in a fundamentally better position than Greece. Its debt-to-GDP is lower, it’s structural deficit is also lower, and it has good export competitiveness. It is the banks in Ireland which are insolvent – and these losses, having been socialised, are threatening the sovereign with insolvency too. The right thing to do would be to de-couple the bank/sovereign issue by rescinding the senior and junior bank debt guarantees. And politically, this would also be favourable with the Irish people as well. Instead, with the bailout, we are seeing the government raid pension funds i.e. the ‘people’s money’ to pay off the debts of the banks, ‘the foreigners’ money.’ That is a solution built for social and political upheaval.
The immediate impact of this kind of action would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation, if you will. Clearly, countries like the UK and the US will choose inflation and exchange rate depreciation instead of default as a way of dealing with the sovereign debt problem. That is certainly part of what QE2 is about. If forced, the ECB could go this route as well.
Just as central banks target short-term interest rates via the Fed Funds market with threats of an unlimited supply of liquidity, central banks could in theory do the same for longer-term rates. During our discussion about quantitative easing in the US, Scott Fullwiler pointed out to me that offering a credible commitment to defend a specific target rate with unlimited liquidity could require less liquidity in practice. That is the Fed’s experience from the Fed Funds market.
I see this as only a fix for the liquidity issues – and not as a fundamental solution in that sense. For this to work as a longer-term solution, this carrot would need to be offset by some sort of stick regarding budget deficits and bank capital. Otherwise, the moral hazard this invites will make one unsuccessful in solving the fundamental issues.
Default
The second path is more tricky and therefore not likely in the near-term unless it is forced upon the Europeans. As Edward Hugh pointed out yesterday, Greece is not headed in the right direction. Default is inevitable. I don’t think the default issue is controversial anymore. The question now is who defaults and under what conditions. What Europe should strive for is a default by the ‘right’ players under the most benign conditions. And so that means this option is not mutually exclusive with the first. You could have a monetisation-default scenario whereby the monetisation leads to the ‘right’ players defaulting i.e. the insolvent as opposed to the illiquid. (link to full article)
