The Consequences of Euro Debt Monetization

As the pressure on ECB grows to step up its “bid of last resort” for European sovereign bonds, the folks over at Zero Hedge ask the very important question what are consequences if the ‘zone resorts to massive debt monetization? Here is one plausible scenario we’re looking at.

Let’s start with the simple observation that there are, at the moment, massive capital flows taking place under the surface within Europe, reflecting capital flight out of the periphery and into Germany. The ECB is providing support to financial institutions that are experiencing liquidity pressures as a result of these flows.

During the 1980’s and 1990’s, the exchange rate of an emerging market country experiencing a monetized bank run would come under tremendous pressure as depositors and investors exited the currency. The central bank would hopelessly intervene, lose billions of dollars of reserves in an effort to hold the exchange rate, and then be forced to devalue. The classic case was the 1994 Venezuela banking collapse.

We suspect euro denominated deposits in the periphery are being exchanged for the same in the stronger core countries, alleviating much of the pressure that might otherwise mount on the exchange rate. No doubt some leaks out of the eurozone into the Swissie, the dollar, or, the Scandinavian currencies. The situation in Europe is somewhat similar to a U.S. saver moving his/her savings from say Downey Savings to JP Morgan as the housing crisis began to accelerate.

Whatever the case, the demand for the euro has remained relatively strong in the core countries as the ECB reportedly sterilizes all bond purchases and liquidity injections. Witness the limited pressure on the currency and its surprising relative strength versus the dollar during the past few months as the crisis has spread.

The question is: what will happen to German money demand if the ECB is forced/resorts to massive monetization of periphery sovereign debt? Just as confidence in a sovereign’s credit worthiness can evaporate quickly, so to can confidence in a central bank. As the Hadledsblatt states below monetary stability and savings is part of the German culture.

Will the German public’s demand for euros remain strong if the ECB begins a mass monetization? If not, will the euro collapse and what will be their currency and “store of value” of choice? Gold? The dollar?

Furthermore, will the Fed and global central banks try an reduce this risk with coordinated quantitative easing? Imagine the reaction of the “crack”/liquidity addicted markets to such a policy surprise. Gold would likely soar $200-300 on such an announcement.

One last point. The Fed’s quantitative easing is not an explicit monetization of U.S. government debt to make up for a loss of confidence by the markets. A de facto monetization of the deficit or a “helicopter drop” of money? Probably. But comparing what the Fed is doing and has done to the situation the ECB currently finds itself in is complete nonsense, in our opinion.

We concede an argument can be made that some of the Fed’s purchases of mortgage securities has been a monetization of bad debt but these securities are being paid off at maturity, we assume, and are rolling off the Fed’s balance sheet. The proceeds, of which, are being used to purchase more securities.

If the U.S. ever reaches a point where the Fed has to fully backstop the U.S. government, or even just 40 percent of the government, are you going to be caught long dollars and Treasury bonds? Some believe it will never happen because of the Fed’s backstop. We’re not so sure.

The nonlinear dynamics of the crisis which began 2008 makes the end game more uncertain and unpredictable. Nobody knows when, where, and what are “tipping points.” Not even the “Super Committee” of the U.S. Congress.

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