Wednesday, September 7, 2011

European Central Bank Making Things Worse for Italy and Spain By Trying to Make Things Better

That Just Doesn’t Sound Right - But It Is

The interesting thing about the Financial and Economic crisis now enveloping Europe is its diversity and complexity.  It is not single issue crisis, because Europe even it is semi-united status is still a union of independent diverse and complex economies.

The problem in Spain and Italy has been weak economies, weak and ineffective governments and high deficits, resulting in large borrowings in the private market by both countries.  The private markets, not being as stupid as they used to be, see the problems in these two countries and don’t want to buy their debt any more, at least not at interest rates that are low enough to enable the governments to continue borrowing.

Jean-Claude Trichet, the Perplexed
President of the European Central Bank

Stepping into this dilemma is the European Central Bank (ECB).  Its solution is for the ECB itself to buy the debt, pushing up prices, lowering interest rates and allowing the economies of Spain and Italy to survive for at least another day or month or year or so.  This would seem like a reasonable solution, but in the long term it is making the problem worse.

Because the ECB is depressing yields on Italian and Spanish debt below that which the private market requires, private investors (banks, financial institutions etc) are even less inclined to buy Italian and Spanish debt.  If the ECB suddenly stops supporting the Italian and Spanish debt issues before those countries can start solving their governmental and economic problems, rising interest rates will put things right back where they were.  So at this time Italy and Spain are "hooked" on ECB purchases of their debt.

This means even more ECB purchases to prop up the deficits being generated in those countries.   This means even greater pressure on austerity measures in those countries to reduce the deficit.  This means even lower economic growth in those countries, which will lead to higher deficits, more civilian unemployment, more unstable governments and pressure for higher interest rates.

The Law of Unintended Consequences rules with a heavy hand.

 All of which means the ECB will have to have more rather than less intervention in the European sovereign debt markets.  At the end of this process are two divergent paths.  One path leads to an integrated European financial system, with the European community issuing and/or guaranteeing Euro debt.  The other path leads to a partial disintegration of the European financial system, due to the economics of the situation and the political pressures that do not, for example, allow German taxpayers to take responsibility for Italian government debts.

How this all turns out is fascinating, but not in a good way.  The Law of Unintended Consequences Rules.

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