Thursday, December 8, 2011

ECB Paying Price of Faulty Inflation Policy

By Grant de Graf

The ECB has cut interest rates by 25 points to an historic 1%. This was generally anticipated by the market. Apparently, the ECB has also lowered the quality of assets that are required for banks to avail themselves of credit lines. This is necessary to provide additional liquidity into the system, as a consequence of the lock-up that currently prevails in financial markets.

The decision by the ECB to raise interest rates over the past few years, in an apparent attempt to constrain inflation, was always misconceived. See "ECB Caught in Inflation Trap."  This was a consequence of the inaccurate method which the central bank used to predict inflation, caused by incorrectly attributing inflation to changes in the supply and demand of goods, rather than money supply. Europe is now paying the price.

The ECB has indicated that it will not participate in any large scale purchase of bonds, in an attempt to constrain yields. This is positive. There is no reason for the central bank to currently embark on such an initiative. If it needs to provide its members with further funding, it should issue its own bonds, which will be priced at a lower rate. The ECB could then afford these members a private facility for a credit line that it may require.

Tuesday, December 6, 2011

What Goes Round Comes Round, Merkel and Sarkozy Operating With Short Fuse

By Grant de Graf

About two years ago, at the height of the economic headwinds that were sweeping the U.S., the Standard & Poor's credit rating agency came under heavy fire. The company was accused of being lax in its attitude towards risk assessment. Earlier today, the S&P rating agency issued a warning: it was reviewing a possible downgrade for 15 of the 17 Euro-zone nations. "Snooze and you will loose," is the talk that is being vented in banking circles. Apparently much of Europe has responded in rage. In retrospect, should anyone be surprised?

Merkel and Sarkozy are seeking ways to strengthen fiscal discipline within the EU, through changes in the EU treaty that provide for punitive sanctions against those nations that violate certain expenditure targets. Timothy Geithner is reported to be on a flight to Europe, to lend his assistance to resolving the crisis. It appears as though a strong measure of commitment to resolving the challenge, is being implemented.

The Odd Couple

The initiatives that Merkel and Sarkozy are pursuing are aimed at bringing into line fiscal policy with monetary policy, an incongruousness for which the EU has been long criticized. However, the issues are not just constrained to containing government spending. They also extend to taxation. Ultimately, Germany and France will need to pay for the inefficiencies of lagging nations and PIIGS. And perhaps that is the way it should be, as these stronger nations are the real beneficiaries of the Euro. But let it be said, that the advantage they enjoy is derived from the Euro, and the favorable exchange rate at which they can bring their goods to market. And therein lies the inefficiency. Because really for Germany and France, the Euro should be much stronger. If it were not for the inadequacies of PIIGS it would be. The constrained value of the Euro affords Germany and France a considerable price advantage. Conversely, the weaker nations compete at a significant disadvantage.

Recently, Tony Blair was interviewed by the WSJ regarding the future of the Euro. See "An Encounter With a Diplomat in New York." He made the point that although the political arguments for a united Europe and the Euro are significantly compelling, the economics still need to work. The inefficiency of the Euro, the skewed advantage that it affords some nations at the expense of others, was effectively the point to which he was referring. In its current state, the Euro is fundamentally flawed. That doesn't mean that it cannot be rectified. It can. But it will mean that some significant changes need to occur. The current track which its leaders are pursuing is misdirected, as it does not address the fundamental flaws of the Euro.

Although the attempt by the EU's leaders to bring fiscal policy in line with monetary policy, is a move aimed at addressing a specific weakness of the union, it falls short of addressing a more fundamental issue and fails to deal with the attribution of taxation policies. While it may be conceivably possible and even equitable, for Germany and France to pay for the inadequacies of PIIG, the electorate of those stronger nations will never buy into such an arrangement. Politically, that means that Merkel and Sarkozy are operating under a very short fuse.

Monday, December 5, 2011

Austerity Will Sink Italy

By Grant de Graf

Italy has taken the step of approving major austerity legislation, announced by Italian Prime Minister Mario Monti. This will see significant cuts in government spending. The move is being heralded as a new turning point in the European Sovereign Debt Crisis and a step towards salvation. Unfortunately, there is one point that policy-makers are failing to grasp in dealing with the crisis: austerity is good for preventing a crisis, but it is not a remedy for resolving one.

Regrettably, this will mean that Italy will probably go the same way as Greece, Spain and Portugal. First they will have the demonstrations, then the riots; and then this shall be followed by a change in government.

Even Britain has acknowledged this phenomenon to some degree. Last week Prime Minister David Cameron announced an initiative that will facilitate the provision of further credit to small businesses. This is a positive step. The chance that such a program will be Shanghai-ed is a concern, as generally bureaucratic initiatives tend to be too top heavy and slow to make an impact on the market. The U.S. had a similar experience a few years a go, when at the height of the crisis they attempted to feed liquidity into the system. The single area that government funding failed to find expression was in the the small business sector, namely as a result of the strict lending conditions that were being imposed on banks by regulators. Hopefully, Britain will have a work-around solution. However, when it comes to government led initiatives, a positive expectation may be ill-conceived. One would suffer the risk of being accused of grasping at illusions of grandeur.

Sunday, December 4, 2011

The Winter of Forgotten Hope

By Grant de Graf

A chilly breeze blows across the Alps as winter approaches and politicians continue to search for an economic solution to what is being called the mother of all sovereign debt crises.

Europe spent years of dedicated service in building the Euro with its respective European partners, producing a currency that represented a significant part of the global economy. Today the vision which politicians rallied to support, lies in virtual tethers.

Tony Blair, former British Prime Minister, predicts that Europe has weeks to decide, whether the Euro has legs. German Chancellor Merkel has issued a call for unity and stronger financial discipline among members. Does that mean that the end is nigh? Economically speaking almost everyone agrees, including the leading players within the EU, that in order to survive the Euro has to undergo some fundamental changes. Seemingly there is somewhat of a mismatch between the political determination of European leaders to protect its currency and the viability of the economic blueprint that is associated with the Euro.

One ponders whether Europe's leaders have the economic skill and face to be able to structure a plan that can save Europe. Sometimes it takes a greater sense of courage and wisdom to release the eagle from capture, than to ensnare it. The art of falconry was never Europe's strong point.