Money and Finance

Hussman Weekly Market Comment: A Brief Primer on the European Crisis

With regard to the problems in Europe, investors have taken a great deal of hope from the promise of coordinated central bank "liquidity" operations in the event of deterioration. The problem here, in my view, is that whatever amount of liquidity central banks create, it cannot address the structural problem, which is insolvency and the need to restructure debt of peripheral European governments and the European banking system. Even if liquidity operations help to stabilize the markets, we will quickly return to a pattern of recurring strains. Make no mistake, Europe is in a solvency crisis. Central bank liquidity, coordinated or not, will not solve this problem.

As I noted in March 2008, at a similar point in the crisis cycle: "Think of it this way. A liquidity crisis is when you write a check for more than the amount in your checking account. You suddenly realize that you need to sell a big securities position to cover it, but selling everything at once might only get you "fire sale" prices. In this case, you need a loan for a few weeks to give you time to work out of your securities position. Without that short-term "liquidity," the check might bounce even though you really do have the assets to pay it off. In contrast, a solvency crisis is when the only asset you have to cover that check is an IOU from your Uncle Ernie, who keeps promising "I'll pay you every dime as soon as I win it back on the ponies."

Government always faces a "fiscal constraint" in that spending can only be financed in one of three ways: tax revenue, bond issuance, or money printing. In the "money printing" option, the government first issues debt, but the central bank permanently buys that debt and permanently creates currency. So a permanent purchase of debt by the central bank is effectively a fiscal operation - a solvency operation. In contrast, a liquidity operation involves a temporary purchase of government debt by the central bank, which creates new currency and bank reserves. But to be a liquidity operation, that operation must also be subsequently reversed so the government debt doesn't permanently reside on the central bank's balance sheet, and so that the money supply isn't permanently elevated.

Understanding this, it becomes clear that even coordinated central bank liquidity operations are at best a short-term response to European crisis. Indeed, even money printing by the European Central Bank itself can only address Europe's solvency crisis if it buys peripheral European debt without ever being repaid, and permanently creates new euros to do it. Indeed, at prevailing debt/GDP ratios, it is unlikely that the ECB would ever be able to reverse massive purchases of peripheral European debt without provoking a fresh crisis. It follows that massive purchases of peripheral debt would amount to an implied fiscal transfer from other European countries, since normally, all European countries would share in the "seignorage" revenue from new money creation. Not to mention that EU treaties would have to be changed to allow the ECB to rescue individual countries.

So the idea of a quick fix through ECB printing is an illusion - that solution would still effectively represent a massive fiscal transfer from other European countries, because the creation of new euros would otherwise be able to fund new spending within the Euro zone. Massive, permanent money creation might "save the euro" in its present form, but would also wreck the euro in substance through inflation and depreciation. The political decision is whether the people of Germany and stronger European countries want the euro enough to make permanent fiscal transfers (or permanent currency creation that amounts to the same thing) to peripheral European countries. The real fate of the euro rests with that political decision, not with central banks, and the final decision on that matter will not come without extreme disruption in any event. Maintaining the Euro will require European governments to cede their fiscal sovereignty to a central authority, and that will not be easy unless major disruptions make that choice better than the alternatives. Departing from the Euro would best be done in sequence from stronger-to-weaker (which would free the remaining countries to agree on whatever depreciation and inflation rate they choose), rather than weaker countries first, but any breakup path would be disruptive as well. The realistic perspective here is to accept the likelihood of significant and continuing disruptions from Europe, and to accept various investment risks within that context.

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