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Jean-Claude Trichet: Debt, Stimulus & Inflation In The Eurozone…

|Includes:CurrencyShares Euro Trust ETF (FXE)

by Martin Denholm, Managing Editor, Smart Profits Report

If inflation had an arch-enemy, it would be Jean-Claude Trichet.

Since assuming his position as president of the European Central Bank (ECB) in November 2003, the Frenchman has made inflation-fighting his M.O.

Trichet and his fellow ECB board members have a steely resolve to keep the 16-nation Eurozone’s inflation rate as close to the bank’s 2% target as possible. And although inflation isn’t a problem at the moment, many believe it’s only a matter of time before it will be. So inflation-fighter Trichet has made a pre-emptive call for restraint.

In an interview with Europe 1 radio, Trichet said that with many European governments swimming in debt and massive amounts of money pumped into the ailing Eurozone economy, debt accumulation and stimulus efforts should stop.

No doubt he’s mindful of the inflationary impact all this could have on the euro. But Trichet is contradicting himself. Here’s why…

Stop The Borrowing… Stop The Spending

Trichet’s comments come on the back of the ECB’s latest “Financial Stability Review,” which says Europe’s banks alone face $283 billion worth of write-downs, both this year and next.

And even that might be sugar-coating it.

In April, the International Monetary Fund put Eurozone bank losses at a staggering $750 billion.

If you’re like me, you might be wondering how/why there’s such a big gap in the figure. According to the Financial Times, the ECB and IMF have different assumptions on loan performances. However, the paper estimates that with write-downs through May, the figure is closer to $540 billion.

Either way, the figure is aside from debts that governments have amassed, plus Europe’s economic stimulus money, which doesn’t just pay for itself with no after-effects.

And Trichet says debt-laden countries should stop borrowing, given that current stimulus efforts are “sufficient” and “completely extraordinary.”

Apart from Tuesday’s record move, that is…

Borrow Now… Or Pay Later

Just like that… the ECB pumped another several hundred billion euros into the economy yesterday.

The measure, announced in May, involved releasing unlimited one-year funds into the market to help financial institutions lock in funding at a 1% ECB interest rate for the year. It was done under the assumption that Eurozone interest rates won’t fall any further for the foreseeable future, and perhaps not change at all until 2010. The ECB is essentially encouraging a kind of “do it now while you have the chance” offer, hinting that it could increase the rate in future.

It was the ECB’s second such move, following its similar $483 billion cash injection in December 2007. That was a record at the time - and the Financial Times says this latest stimulus is expected to break it.

So much for Monsieur Trichet calling for borrowing and stimulus efforts to end. It appears he’s contradicted himself here.

Jean-Claude Vagueness

In addition to his probable concerns over higher inflation at some point, Trichet warns that more borrowing and spending will cripple the Euro region for future generations. And his call for restraint comes amid his assertion that global economic activity should return “close to stability” later this year, with positive growth in mid 2010.

Personally, I don’t know what “close to stability” means - not in today’s wild economic climate - but bankers are masters at being vague! Nevertheless, several European countries have already said they’ll halt spending.

That’s all very well. But just like the U.S., the banks hold the key to so much of what happens next…

A Stress Test… Euro-Style

In the wake of the grim ECB and IMF figures on European banks’ losses, some have called for rigorous “stress tests” of Europe’s financial sector, since so much of the Eurozone economy hinges on its fortunes.

And those calls could grow louder, given what ECB vice-president Lucas Papademos calls “negative interplay” between the banks and economy. In addition, with the financial sector already at high risk, the ECB is concerned that some banks might not be able to handle shocks if they don’t have enough capital.

But by figuring out which ones are capable of withstanding upheaval and which ones need help, it would allow Europe to tackle the problem and consequently boost consumer confidence in the system.

The trick is balancing that need against what the ECB’s report called becoming “too reliant” on its bailout money.

However, the ECB could not initiate a formal move, since it doesn’t have authority to regulate banks. Instead, it would have to come from individual countries.

That’s the drawback when you have a “one-size-fits-all” central bank in terms of monetary policy, but with limited powers elsewhere.

Behind all this borrowing, bailouts, and debate is the single European currency - the euro - shared by the 16 Eurozone nations. The ETF that represents it is the CurrencyShares Euro Trust (NYSE: FXE), which has climbed 8.5% over the past two months. And despite Europe’s ongoing issues, it’s down just 4.7% for the year.

It’s still too early to tell if Europe is over the worst of the recession, or whether the ECB’s latest low interest stimulus funding will prop up the balance sheets of European banks and free more capital. But since the market leads the economy, you can gauge Europe’s progress by looking at assets like FXE.

Best regards,

Martin Denholm

Disclosure: No positions

Stocks: FXE