Posted on October 19th, 2012
European defaults on Sovereign Debt may trigger Double – Digit Global Inflation
The European crisis used to be called the European sovereign debt crisis. Later on, it was referred to as the European banking crisis. Finally, it winds up being just the European crisis. Is there a difference? Not really. Experience in Japan, the US, Ireland, Spain and numerous other countries reveals what ought to have been clear: no developed economy can afford to have one of its large banks go under and when the risk is severe, the local government (including the central bank) is forced to take over the ailing bank and/or back its liabilities. And vice versa, when the government cannot find buyers for its debt, the local banks will buy it, because if the government reneges on its debt, so will the local banks who normally own much of the existing government debt. Of course if the government and the banks go bankrupt, so will the whole economy.
These facts are best demonstrated by the evolving story of Spain. At present, nobody would buy Spanish government debt except for domestic banks or an occasional large speculator who thinks he is buying these bonds cheap and will eventually be able to sell them (directly or indirectly) to the ECB. After all didn’t the president of the ECB, Mario Draghi, say he will do everything necessary to support the EMU? And didn’t the EU summit decide that the ECB will buy any amount of Spanish government debt necessary to support their prices. And wasn’t the only precondition that Spain will ask for aid (and by the way also sign a memorandum transferring the power to run fiscal policy to Germany)?
Meantime, only a slight delay. German finance minister, Schauble, said he does not believe the Bundestag will approve this aid to Spain so soon after € 100 billion was allocated to support the Spanish banks. But there could be another slight problem. If the Germans are worried about a `measly` € 100 billion, what will they say when they find out that the ECB has to finance all the maturing Spanish and Italian debt plus their budget deficits, over 3 years, a total of € 3 trillion or more? Yes, the IMF, Japan and even China may possibly come to the rescue – provided they miscalculate the amount involved. But they all, including Germany, the Dutch and other smaller economics cannot shoulder this task.
Shortly, when all of this becomes clear, what else will follow? The Spaniards may revolt when they see the punishment the Germans have in store for them, but assume for the moment that they are so demoralized already that they will not go to the streets. And assume also that that applies to the Italians and the Greeks (and the Cypriots) too. To be optimistic, assume also that Catalonia does not secede so fast from Spain. And in the same optimistic vein, assume that not all holders of Spanish and Italian debt with up to 3 years to maturity will line up to sell it to the ECB. And that Chancellor Merkel survives all of this for a while. So the ECB will only be called upon to buy several hundreds of billions in the next few months, and so it does. The money paid for Italian and Spanish debt will of course flood Europe, including Italian and Spanish banks and French and German banks that own Italian and Spanish debt. And the ECB may be called upon to bail out the latter group of banks too if they own obligations other than short- term soverign debt.
This flood of newly created money will come on top of € 1 trillion in “liquidity” the ECB already injected several months ago and a few hundred billions injected into or now expected by the Spanish banks and in the support programs for Greece, Portugal, Ireland and Cyprus. But given the size of the needed aid for Spain and Italy, it is likely that all of this will not suffice and the Eurozone will eventually have to be taken apart.
Meantime, the Fed has engaged in money (reserve) creation on an enormous scale as well. Its balance sheet has increased 200% in the last 4 years. And since the banks were not able to use all of the reserves they accumulated, their excess reserves grew to $1.5 trillion. China actually increased its money supply much faster.
Eventually Germany will have to decide that the burden of keeping the euro intact is too heavy whether before or after funneling a few more hundred billions of euros into the weak Eurozone economies . When it comes, the decision may be made by the Bundestag, by Merkel, by the courts or by the general public. (This decision reportedly has already been made by the Bundesbank). As it stands now, Spain will soon after that default on its obligations, followed in short order by Italy and probably by France. Investors the world over will re-learn that government obligations are not “risk free”, and neither are bank obligations. But there is no reason to believe that this lesson will be confined to Europe. Investors (savers) in Japan may finally conclude that their government obligations are too large to be safe, and investors in US federal debt securities may soon reach the conclusion that these obligations are increasing too fast for comfort. Finally, China which holds all these obligations in huge quantities may be hurt too.
Obviously, there is a big difference between the Eurozone members who can’t each just print more Euros on their own and the US, for example, that has been doing just that (in US. dollars, of course) big time in recent years. Therefore the process in the US will be different. As people lose confidence in government obligations they will naturally also lose trust in those little government pieces of paper (or plastic, or book entry) called money. After all they are only different from bonds in that they say “In God We Trust” and other interesting imprints. As investors lose confidence in government paper and rush for real assets such as real estate or gold or even stocks that represent some real income stream, inflation will start rising.
The inflation foreseen here is not the type of “cost push” or “demand pull” that the US experienced in the 1970’s. Rather, it is more akin to the hyperinflation experienced by Germany in the early twenties in that it is caused by loss of confidence in government obligations. It is unlikely to reach anywhere near the levels seen then, but could reach levels not even imagined by most analysts, let alone being reflected in the markets.
In some respects the risk of inflation now is even harder to fight than it was in Germany. First, its nature is global. So much so that it is not even possible to tell where it will develop earlier. Second, some governments and central banks are actually trying to boost inflation intentionally for various reasons. These include Germany, Japan and the US. Finally the speed at which it could develop and ratchet around the globe may make it intractable.
All of this does not have to happen but it will take a lot of ingenuity and flexibility on the part of several major decision makers to avoid it. Some, like Merkel, Draghi, Bernanke and others would have to reverse policies. And the chances of that are slim at best.
The writer is Chief Economist and strategist of 4L Macro Opportunities SP