Insights & Advice

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The ECB: between a rock and a hard place

Will the ECB become the lender of last resort?

All eyes are on the European Central Bank. The financial risk in Europe has escalated to a point where investors see no way out unless the ECB comes to the rescue. The problem is that the bank’s charter makes that difficult.

Back in the day when the ECB was first established, its member countries insisted that its role would be confined to controlling inflation through monetary policy. Unlike the U.S. Federal Reserve, there was no directive to manage unemployment in their guidelines. This is important because in this country managing unemployment allows our Fed to goose the economy (by printing money) despite the risk of future inflation to reduce the jobless rate.

The Fed’s quantitative easing programs was all about buying U.S Treasury bonds, reducing interest rates and therefore jumpstarting the economy. Some think it was a useless effort while others argue that without it our country would be mired in a multi-year recession with far higher unemployment.

In Europe “too big to fail” is not about the banks as it was in America. It is about a growing list of countries whose government bonds are plummeting in price as their interest rates rise. If allowed to continue, it will pitch many of the southern tier nations into a recession or worse. In some cases, such as Greece, we are talking bankruptcy. Although that would be negative, Europe could survive it. If the same thing happens to Italy or Spain, it would take down the entire European Community and destroy the Euro.

Although the EU has attempted to head off the contagion, they have done too little, too late. The amount of money that would be needed to calm investors’ fears of a European meltdown at this point is not available outside of the ECB.

All week, markets have been hoping against hope that the ECB may find a way to save Europe without violating their charter. There is talk that maybe the ECB could lend money to the International Monetary Fund, which in turn could buy Euro debt. Although that would be technically legal, I doubt that Germany would go for it.

Germany is the major stumbling bloc in resolving the ECB’s dilemma. It is diametrically opposed to allowing the ECB to bail out Germany’s neighbors. After its own hyper-inflation experience during the Weimar Republic, Germans have a horrific aversion to anything that might trigger inflation.

They believe that by bailing out Italy and Spain, or even the PIGS, via an ECB quantitative easing program it would open the door to inflation throughout the EU. Germany also believes that it would nullify any incentive now or in the future for these spend thrift nations to mend their ways.

If nations feel that the ECB will bail them out regardless of their economic policies, argue the Germans, what incentives do they have to change? The Germans fear that the ECB could become a political football with Southern tier nations continuously issuing more and more debt to maintain their lifestyles while the ECB prints money to buy them up.

The Germans have a point. But at the same time, if nothing changes soon, the Euro will be kaput, (something the Germans would hate to see) since their economy has benefited mightily from its inclusion in the EU.

Until there is some clarity on this issue, expect the markets to continue to swoon one week and celebrate the next. We are getting dangerously close to the recent bottom on the S&P 500 trading range, around 1,200. If it breaks there, we could see further declines. I’m betting we hold. There is an increasing stream of good economic data coming out of the U.S. that investors are ignoring. I think that is a mistake.

Posted in A Few Dollars More, At the Market