John Hussman clarifies that the European bailout last week was a loan,
not a printing effort. It will be sterilized. This could have direct implications for the
global stock market, as it may continue to head lower. Stay tuned this week,
as technically a follow through to the downside is crucial for the bear case.
We could also be at risk of yet another “flash crash” due to the lack of liquidity
in the global financial system.
John P. Hussman, Ph.D.
Last week, the European Central Bank pledged to spend as much as 750 billion euros (about a trillion US dollars) in an attempt
to discourage market concerns about European debt, particularly that of Greece, Portugal and Spain. The intended message
was to show the markets – particularly bond market “vigilantes” speculating against European debt – that the ECB has deep
enough pockets to thwart the mounting pressure on European debt and the euro itself.
ECB President Jean-Claude Trichet has been quick to deny concerns that the move by the ECB will be inflationary, emphasizing
that the intervention will be “sterilized” in order to prevent a major increase in the amount of euros outstanding. This is “totally
different,” he argued last week, from the massive increase in monetary base that has occurred as the U.S. Federal Reserve has
bought up over $1.25 trillion in debt obligations of Fannie Mae and Freddie Mac. A “sterilized intervention” is one where the
euros created through the purchase of distressed Euro-area debt will also be absorbed by selling other assets from the ECB’s
balance sheet, in order to take those euros back in.
In order to evaluate the arguments being made, it’s helpful to understand the balance sheet of a typical central bank. Whether
in the U.S., Europe, or elsewhere, the basic structure is the same. On the asset side, the central bank has government debt
that it has purchased over time. A small proportion of total assets might be held in “hard” assets such as gold, but primarily,
the assets of each central bank has traditionally represented government debt – mostly of its own nation (or in the case of the
ECB, euro-area governments). As a central bank purchases these securities, it creates an equal amount of liabilities, in the
form of “monetary base” (currency and bank reserves).
Notice, for example, that the pieces of paper in your wallet have the words “Federal Reserve Note” inscribed at the top.
Currency is a liability of the Federal Reserve, against which it has traditionally held assets such as Treasury securities, and prior
to 1971, at least fractional backing in gold.
In this context, consider the ECB’s proposed 750 billion euro line of defense. Essentially the ECB is saying “We stand ready to
buy as much as 750 billion euros of distressed Euro-area debt in order to defend the euro.” Simultaneously, despite the fact
that Euro area countries are running large fiscal deficits, the worst being in Greece, Portugal and Spain, the ECB is saying
“However, we intend to sterilize this intervention, which will ultimately require that we sell Euro-area debt into the market in
order to absorb the euros we create.” The only way that both statements can be true is for the ECB to admit “Therefore, we
are fundamentally promising to debase the quality of our balance sheet, by exchanging higher quality Euro-area debt with
lower-quality debt of countries that are ultimately likely to default.”
Far from being “totally different” from what the U.S. Federal Reserve has done, the ECB is essentially promising exactly the
same thing – to corrupt its balance sheet and debase its currency in order to protect the worst stewards of capital from the
consequences of bad lending and poor investment.
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