The Euro - a Greek Drachma in Disguise

Thursday, May 20, 2010
The Euro keeps tumbling as international investors are loosing faith in the Eurozone. The currency has so far fallen 14 percent against the dollar this year. There is fear that contagion could trigger "Greek" debt crises among other EU countries with weakening fiscal positions, and that European banks could realize substantial losses as a result. Thus the European interbank market is freezing up. A joint "rescue package" by the members of the Eurozone, the European Central Bank (ECB) and the International Monetary Fund (IMF), amounting to around 1 trillion euro, was hastily brought forth in an attempt to stop the accelerating crisis. This temporarily calmed markets, but now fear is back in play. “[I]nvestors were impressed at first," says Marco Annunziata, chief economist of UniCredit, "but now some investors question the probability of the survival of the eurozone.” Thus, the initial enthusiasm for the bailout is fading as the "rescue" amounts to nothing more than a short-term solution to a profound fiscal and structural problem. Bond holders realize this, and are therefore becoming ever more reluctant to invest in Eurozone government securities. What prompted these dramatic measures on the part of European policymakers were, according to President of the European Central Bank Jean-Claude Trichet:
"we had a continuous deterioration of the situation in the financial markets, both in Europe and, as a consequence, at the global level...  [A] number of important indicators - spreads on sovereign bonds in Europe, CDS spreads and the situation in the interbank market - were signaling the spreading of severe tensions."
As part of the plan, the ECB will now buy government bonds of Eurozone members, something it only a short time ago said it would never do. Also, it will accept as collateral government debt with less than investment grade, i.e. government junk bonds. This retrenchment on the part of  Trichet has led to concerns that the ECB is loosing its indepence. Though he repeatedly has tried to assure markets, as well as EU politicians and voters, that these actions will not compromise the ECBs adherence to "price stability"--setting off a spiral of Eurozone inflation--there seems to be good reasons to believe that inflation is exactly what we will see in the near future. Though the ECB will "sterilize" purchases of government bonds (thus keeping the size of its balance sheeet intact, while changing its composition), in the longer run, a full-scale sovereign bailout will mean the monetizing of debt, i.e. money creation, simply because the ECB's balance sheet is not large enough to contain the crisis, should the situation deteriorate. This is similar to what has been happening in the U.S. In the first phase of the financial crisis, the Federal Reserve (Fed) changed the composition of its balance sheet, basically buying up bad assets and selling good ones. When the crisis deteriorated, however, the Fed rapidly expanded its balance sheet, buying up bad mortgage debt by creating new money. Today the Fed is faced with a bloated balance sheet and a mountain of junk bonds. The same could happen to the ECB, creating a huge potential for inflation and seriously compromising the future conduct of monetary policy within its formal mandate. Thus the ECBs image as the successor of the German Bundesbank--which conducted sounder monetary policies than most other central banks in the postwar era--could be shattered. One market participator, David Bloom, who is head of foreign exchange strategy at HSBC, said:
“Prior to the current crisis the euro was deemed to be the Deutschemark in disguise. But the rise in sovereign risk has changed this perspective. It now seems that people think it is a drachma in disguise.”
An escalation of the European sovereign debt crisis--which could also involve several systemically important financial institutions--would increase the pressure on the European Central Bank to resort to outright quantitative easing, i.e. buying governments debt with newly printed money, and thus to step up its bailout programs. This could spell badly for the European economy as well as the future of the euro. On May 18, the Spanish government came close to its first debt auction failure. “It suggests the European Central Bank may have to buy a lot more bonds than it first thought to prop up some of the peripheral eurozone bond markets,” says Steven Major, head of fixed income at HSBC.