INVESTORS OF LAST RESORT / BARRON´S MAGAZINE EDITORIAL COMMENTARY ( A MUST READ )

Editorial Commentary

SATURDAY, AUGUST 27, 2011

Investors of Last Resort

By THOMAS G. DONLAN

Subsidized borrowing at rates that belie the risk is a sign of further trouble.


Can central banking save the world? Almost certainly, it cannot. Easy money is the coin of the central bankers' realm. Its easy money cannot be the cure for problems generated by too much debt, unless we imagine rampant inflation to be an obscure form of economic health.


That's the bad news, especially for Europe and the U.S., which are depending on their central bankers to save them from the second Great Recession, or Great Depression, or whatever history will call it.


The good news is that the world doesn't actually need saving, except from the ministrations of the central bankers. Our fully developed part of the world needs to go home and sleep off the effects of too much debt; the newly industrialized world needs to lend less and spend more. This is one of those times when a recession may be better than the alternative.


But markets around the globe spent the week writing speeches for Federal Reserve Chairman Ben Bernanke. Traders imagined him saving the world for another few months with a third round of quantitative easing, purchasing other people's paper debts with his paper money. QE3, for short.


Bernanke, however, finessed the traders. He said nothing about QE3 in his speech Friday. His silence could be golden, but more likely, QE3 is under way without acknowledgment.


Road Show


Across the Atlantic, the European Central Bank and its President Jean-Claude Trichet have taken up quantitative easing of their own, so far on a much smaller scale than the American version. It has been a large reversal, however, from the prior European policy of monetary tightening, a policy that was appropriate for the 30% of the Euroland that is German, but was adding to the woes of the PIIGS (Portugal, Ireland, Italy, Greece and Spain).


It is widely accepted that the PIIGS can't deleverage fast enough by budget cuts to satisfy their lenders, so it is also widely accepted that they need easy money to throw at their bad debts. The rest of Europe is also eager for a little more stimulus, as even German economic growth is evaporating.


The question isn't whether monetary or fiscal stimulus is wise. The question is how to get the money, mostly out of Germans. Or, more accurately, how to get it out of Germans without making the Germans as angry about losing their money as the Greeks have been about not getting it.


Some methods of mulcting the German public, such as direct transfers from wealthy countries to poor ones in a strong political union, are too obvious. The solvent countries have swallowed multibillion-euro bailouts for Greece, Ireland and Portugal, but Italy and Spain will require multitrillion-euro handouts that even the Germans can't afford.

Thus the European Central Bank has become the "investor of last resort." It's buying Italian and Spanish bonds when banks and private investors won't, to hold their interest rates at levels that won't bankrupt the borrowers. The ECB doesn't disclose which countries' debt it holds in its rapidly expanding portfolio, but the fact of its rapid expansion seems to match the sudden ability of Italy and Spain to borrow at rates lower than the risk.


This monetization isn't a solution, of course. It's part of the problem, a part that delays a permanent solution, which helps the whole problem grow beyond the power of any political or financial remedy.


United We Sit


One permanent solution is a stable political union of Europe, in which a central government and the central bank manage the finances of all the nations in their common interest, so profligate countries give up their spendthrift ways. It is as likely as the chance that all the nations will give up their unique languages and start speaking Esperanto.


The closest that any Europeans are willing to come to political union is a debt union, in which Europe issues eurobonds on the full faith and credit of all 17 nations of Euroland. Germans, however, rightly perceive this as issuing Greek bonds with a German signature. "Collectivizing debt," sniffed German Chancellor Angela Merkel, an enemy of collectivization in any form.


As Herman van Rompuy of Belgium, chairman of the European Council, said last week, "We could have eurobonds only when there is, indeed, real budgetary convergence, when everyone is running a balanced, or practically balanced, budget." He didn't add that when that day dawns—if it ever does—eurobonds won't be needed.


Merkel and French President Nicolas Sarkozy have discussed using political chit-chat as a substitute for political union. They suggest that Europe hold a summit twice a year to enforce the long-standing treaty obligations of all Euroland nations to limit their debts and deficits. It isn't clear how the summiteers would enforce anything that they didn't wish to have enforced upon themselves.


The other permanent solution is to give up the euro as the bad idea it has always been. Greece can lead by repudiating its euro debt. That might not be the nicest way to go about it, for there might be serious repercussions for many important banks in several countries.


But if political union is impossible, currency union will also be impossible. European leaders, starting with Merkel and Sarkozy, should recognize that they have left themselves no good choices except an orderly process of reconvergence with reality.

They may believe that Europe is too big to fail, but it isn't necessarily so.