A Solution to the European Crisis

Economics, Premium POM

Debt Deflation, Domestic Assets, and the European Stability Mechanism

By JC Collins

Debt deflation is not something which is in the recent collective human memory bank.  Few alive today have lived through a period of debt deflation.  Those who have would only retain vague memories of the experience from early childhood. So it is not surprising that debt deflation has not been recognized or expected by the majority of people today.

With global GDP contracting and money velocity at all-time lows, world-wide deflation is a reality that cannot be ignored and denied.  All of those who expected QE to cause hyper-inflation and gold to skyrocket by multiples of hundreds are now beginning to realize the full and complex nature of the monetary strategy which has been playing out over the last 7 years.

The QE policies and zero interest rates of most developed economies have been temporary strategies implemented to hold back deflation in order to keep the price of goods from falling below the cost of producing those goods as the system deleverages.

There are two types of interest rates which we need to concern ourselves with.  One is nominal interest rates.  This is the 5% interest you pay on a $10,000.00 loan, which would equal $500.00. Nominal interest rates cannot go below zero.

The second is real interest rates, which are more complex because it takes into account inflation.  Nominal interest rates can be higher than real interest rates when there is positive inflation. When inflation becomes negative, which is deflation, real interest rates can and will exceed nominal interest rates.  Real interest rates have gone into negative territory in many developed economies to hold back deflation.  Now that deleveraging has begun deflation will be allowed to proceed and real interest rates will begin to increase. This is the methodology behind the upcoming interest rate increase by the Federal Reserve.

Though there are neutral net macroeconomic effects as both debtors and creditors gain and lose in a debt deflation scenario, it is the scarcity of credit which affects the largest segments of the economy and leads to a further contraction of the money supply.

This lack of liquidity has to be addressed and availability of credit has to continue during the debt deflation business cycle, at least initially on the supra-sovereign level.

Another effect of debt deflation is an increase in the real value of debts.  This factor adds to the vicious cycle as assets depreciate and money velocity grinds down further.

One of the benefits of a deflation period is it becomes cheaper to produce goods and develop projects which lead to overall GDP growth.  Monetary authorities around the world have been attempting to find a balance between debt deflation, real interest rates, and a method of achieving real growth.

The debt restructuring which will need to take place, both private (personal) and public (sovereign), will have to be enacted in coordination with macroprudential regulations and mandates which will promote global growth at the reduced deflationary costs.

It is debt deflation which will force the restructuring of debt and lead to more sustainable growth in the multilateral framework which is beginning to replace the unipolar USD framework.

The Special Drawing Right (SDR) of the International Monetary Fund does not function like a domestic currency.  Its characteristics are that of a supra-sovereign asset which is positioned within the international monetary framework as a means of maintaining trade and liquidity when domestic assets and regional assets, acting as currency, fail to provide stability.

The SDR is not an alternative but more of a buffer against the volatility and deflation which is taking place worldwide.  Global GDP is contracting and we are in the early stages of debt deflation.

Debt deflation follows the normal business cycle of money supply expansion and money supply contraction.  As the money velocity slows, and global GDP decreases, and real interest rates begin to increase, credit and capital markets will shrink.  The means to capitalize on the cheap growth opportunities of the deflation period will require a non-domestic, or supra-sovereign source of credit, or liquidity.

Let’s take a look at the sovereign debt crisis in Europe.  Greece is at the forefront of the news on a daily basis, with Spain and others not far behind.  The solution to this crisis is perhaps not as complex as first considered, and the structure of the SDR provides a hint of how that solution could be implemented.

Deflation causes a reduction in the price of goods and services.  Deflation also causes an increase in the value of money, which allows for the purchase of more goods and services.  So deflation lowers the cost to produce goods and services while the value of money increases domestically leading to greater purchasing power of those goods and services.

As explained in the post The End of an Era, growth will be important for countries to make their debt burdens more manageable as the debt-to-GDP ratios shrink and countries, such as the United States, depreciate their currency to make exports more affordable internationally.

But how does this help Europe when member countries use the euro domestically?

Let’s suppose that member countries of the European Union reached an agreement where the euro was used for international trade, or inter-European trade, while the domestic currency of each member country was reinstated and used for domestic trade and financial arrangements only.

Further, the domestic currencies could be reintroduced at parity with the euro and allowed to free-float over an agreed upon period of time.  These domestic currencies would depreciate against the euro which would reduce the foreign debt of each member country.

The financial assets and liabilities of each member country could be denominated in the reinstated domestic currency instead of the euro, and would decrease along with the depreciation of the currency.

This would provide a viable and less-volatile solution to the crisis and help stop the contagion from spreading around the world.

The European Stability Mechanism (ESM) would take over the management of the European banking system to prevent a systemic failure of the retail banks left holding the assets during the deflationary period. These banks will carry the bulk of the debt deflation and will be required to issue new liquidity as new growth targets take advantage of the reduced costs of goods and services.

The ESM was discussed here previously in the post The Greek Betrayal and Pan-European Solidarity, where it was stated:

“One of the main components of this restructuring is the “offer” to pass direct managerial control of Greek banks to the ESM, or European Stability Mechanism. This transition will include bank mergers and is to be implemented under the supervision of the ECB.”

Greece is now openly vocal about utilizing the stability mechanisms which are available to them within the ESM. This methodology and solution will continue along this path.  Don’t be surprised if you see the return of Eurozone domestic currencies while the euro itself is used to expand new liquidity through loans to member countries which can then be exchanged into domestic currency.

This new liquidity function of the euro will be facilitated by a similar process through the implementation of the SDR on a larger scale to address the sovereign debt crisis of all countries, and the Financial Stability Board (FSB) will play the role internationally that the ESM will play regionally in the Eurozone.

The large banks around the world will protect their retail divisions by isolating them from the investment bank contagion as debt deflation is managed through the stability mechanisms of the ESM and FSB.

The balance between management of debt burdens, which will require a reduction in the debt-to-GDP ratio of all countries, with debt deflation, and expansion of growth which will be spurred by the global deflation and reduction in costs of goods and services (which will help the debt-to-GDP ratio), will be facilitated by new exchange rate regimes and the depreciation of domestic currency.  – JC