By Arnold Kling
6. Basically the ECB is monetizing bad government debt claims.
His other 11 short points also are interesting.
This is a whole new level of global moral hazard – the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks (and implicitly, north American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will “prevent abuse” by borrowing countries, but it is hard to see how this would really work in Europe today.
As with Tyler’s post, it was difficult to excerpt from the many interesting remarks.
My take is that this is like TARP in that it treats the European debt crisis as a liquidity problem, when at least in part it is a solvency problem. Lately, I have seen several writers argue that a Greek default is inevitable, and no one seems to argue otherwise.
Suppose that banks had to write down the value of their Greek debt by 30 percent or more. At the very least, this would eat significantly into their capital, and they would have to curtail lending. This in turn would make funds scarce for other sovereign debtors. In some sense, this is what should happen–interest rates should rise, and financial intermediation should contract.
Compare what happened in the mortgage market in the United States. Demand fell, as it should have. But supply did not fall as much as it should have, and interest rates did not rise as much as they should have, because the government took over Freddie and Fannie and told them to keep lending at below-market mortgage rates.
In Europe, governments need to cut back their spending, which would reduce the demand for sovereign credit. That may or may not happen–my guess is, mostly not. Instead, the new TARP for Europe will raise the supply of funds for sovereign debt. Perhaps this will indeed turn out to be a monetary expansion in disguise, in which case Scott Sumner should be happy. However, it looks more like the European Central Bank turning itself into a piggy bank, just as the Fed did two years ago. That is, the ECB is now focused above all on saving European banks, and it has lost interest in what happens to the overall European economy.
Tyler Cowen’s line is that we are all poorer than we thought we were. I probably agree, depending what he means. The way I think of it is that we are lowering our expectations of future income and also perhaps discounting future income at a higher rate.
As we adjust our expectations of future income down, the large financial institutions tend to look like beached whales, or at least like whales swimming in shallow waters. What stands out is their large size relative to a shrunken economic outlook. The adjustment to a smaller financial system is one that policy makers are resisting with all of their might. From the perspective of taxpayers, the cost of this resistance could be high. The benefits could be nonexistent.