Adam Smith is spoken of as the father of modern laissez faire capitalism, as well he should be. But the market system Smith described in The Wealth of Nations (1776) no longer exists. Instead, it has morphed into a system of fiat money that owes its existence to another man: the German printer and publisher Johannes Gutenberg (1398-1468). Gutenberg was, of course, the inventor of movable type and the modern printing press, a device without which the modern economy could not function.
As commentators near and far speculate on what 2012 will bring to the global economy and markets, there is little question that one factor will be decisive: the central banks’ printing presses. Both the Federal Reserve and the European Central Bank (ECB) will keep printing dollars and euros around the clock until their presses run out of ink. This vomitoria of paper currencies is the major force driving financial markets around the world. There may be a lot of “known unknowns” to worry about, but central bank money printing is one “known” that can be taken to the bank. The only question is whether the bank will still be able to cash the check when it is asked to.
The likely course of financial markets in 2012 will be determined by the first quarter refinancing needs of European sovereigns. There is €1.2 trillion of debt that must be refinanced in 2012 within the European Union. During the first quarter, €157 billion of debt matures, including €53 billion for Italy. Italy ended 2011 with a 10-year borrowing cost of just under 7%, a level that is unsustainable. If Italy is forced to pay much more than that, the debt crisis will take a quick turn for the worse. Spanish yields are also under pressure, with 10-year interest rates rising to about 5.4% by the middle of last week. Smaller countries like Portugal and Greece are already unable to finance themselves at sustainable rates. While Greece’s bailout plan stumbles to completion, the EU has not begun to work on the inevitable bailout of Portugal. Hungary is also hovering in the background as another trouble spot, with 10-year borrowing costs exceeding 10.5%. World stock markets will be focusing on every European sovereign bond auction and will likely falter at the first sign of weakness.
Europe’s refinancing needs are front-loaded. After the €1.2 trillion mountain in 2012 there are smaller but still substantial financing needs of between €500 and €600 billion in each of 2013 and 2014. In order to prepare for this refinancing flood, the European Central Bank initiated at year end its LTRO (Long Term Refinancing Operation) program, which lends money to European banks at 1% in the hope that the banks will relend this money to European businesses or purchase European sovereign debt. In the week before Christmas, the ECB loaned €489 billion to European banks under the LTRO. Only €210 billion of these loans added to systemic liquidity; the other €279 billion was used by the banks to refinance existing debt obligations. This is only the first LTRO operation planned by the ECB; further loans will be issued under this program in 2012. Unfortunately, banks are much more likely to hoard the money than lend it to businesses that could contribute to economic growth.
The ECB has also been providing significant amounts of liquidity to weaker sovereigns through its interbank lending system known as Target2. Target2 (Trans-European Automated Real-Time Gross Settlement Express Transfer System) was originally designed to facilitate trade among members of the EU. Until the financial crisis, the Target system did not create imbalances and acted primarily as a back-office transaction processing system. For example, Germany had net claims on the ECB of only €5 billion at the end of 2006. But when the interbank system began to seize up in 2007, Target2 began to serve as a major funding mechanism for European businesses. Since 2007, Target2 has been a mechanism whereby Germany’s Bundesbank has loaned €495 billion to the central banks of Greece, Ireland, Portugal and Spain (PIGS). This has passed largely unnoticed because Target2 balances are not carried on the ECB’s balance sheet but are basically buried in the footnotes of the balance sheet of EU member central banks.
Target2 has facilitated a growing balance of payments problem within the Eurozone. Moreover, it has done so in the dark. The weaker PIGS countries have insufficient reserves to fund domestic purchases of goods and services from other European countries, but the ECB has been making up the shortfall through Target2 with funds that it borrows from the Bundesbank, which has more than sufficient reserves to fund Germany’s needs. In effect, the ECB has infused an enormous amount of liquidity into Europe in the form of debts owed by the PIGS to Germany through the medium of the ECB. From a policy standpoint, however, this liquidity infusion was unintended and leaves the Bundesbank vulnerable to the ability of weaker sovereigns to repay these loans. One can only wonder how much deeper into recession Europe would have been plunged without this additional €500 billion of liquidity that is being used primarily to finance inter-European trade. Moreover, as Europe sinks deeper into recession, it is reasonable to inquire how much additional Target2 financing will be made available by the Bundesbank, which is painfully aware of its growing risk.
Printing can (literally) paper over a lot of mistakes. Today, it is being used to paper over a misbegotten fiscal union and ten years of profligate lending to subprime borrowers and failing sovereigns by European institutions. But this is not merely a European operation; the United States is also in the money-printing business both for itself and for the sake of the global system. The U.S. is indirectly contributing to European bailout operations through its funding of the International Monetary Fund, something that will likely raise the ire of Republicans during the 2012 Presidential campaign. More directly, the Federal Reserve is busy printing money to the tune of more than $1 trillion a year in order to fund the U.S. government and its seemingly bottomless obligations.
Printing may appear to be a painless way to stabilize Europe and give it a chance to adopt budget discipline and pro-growth economic policies. But in reality it is neither painless nor effective. There can be no capitalism without risk and loss, and a system that is willing to do virtually anything to avoid pain will never heal itself. While it is difficult to know where to begin criticizing current responses to the European debt crisis, there are at least two points that should be considered indisputable.
First, all of this newly created money is in the form of debt that theoretically has to be repaid at some time in the future. It is highly likely that repayment will take the form of currency devaluation and/or inflation (which are two sides of the same coin). And second, none of this new debt is backed by new assets or discernible economic value. While central bankers are printing money hand over fist, nobody is printing collateral at anywhere near the same pace. Accordingly, the volume of money is accelerating far faster than the growth in the assets it is supposed to finance. Money is simply being minted out of the air and injected into a system already drowning in debt. Anybody who thinks this is going to end well has been reading different history books than we have.