Home > Main > The Eurozone as Neo from the Matrix: Dodges bullets, fights off endless hordes of Bond Vigilantes

The Eurozone as Neo from the Matrix: Dodges bullets, fights off endless hordes of Bond Vigilantes

January 3, 2011

My view on Europe is simple: The Euro will survive.  It will dodge the bullets, like Neo in the matrix.

If you look at MMT the basic idea is “Take Accounting Seriously”.   So when the central bank buys sovereign debt issued in the currency of the central bank, there is no solvency problem.  There may be inflation problems, depending on the level of spending, but this is not due to the central bank buying the bonds – rather, the inflation problem is due to the spending.

The eurozone countries are not spending enough to cause serious inflation problems, particularly when you look at spending over the last 10 years.

As long as the ECB continues to buy the bonds of the countries, then it can stumble along forever.  This behavior does not solve the basic problems of the Eurozone, but it does patch over the worst problem – that individual countries can default.

But the bond vigilantes do not know this.  They will continue to attack, in wave after wave, not knowing their defeat is inevitable due to their black suits, stern demeanor, and evil, heartless nature. But on a more serious note, they just do not know the accounting involved, so they mistake ECB purchases for money creation.

There is no doubt the BVs may achieve temporary victory, but for a true long term victory, there needs to be underlying fundamental support for their position.   This support does not exist – even though the Euro has a messed up design.

If you look at the core idea underlying the Bond Vigilante behavior, it is that the supply of bonds and demand for bonds is all that matters.  However, as Keynes pointed out, and Brad Delong so ably walks through right here, the demand for bonds and money is special because it also has a demand for “liquidity” inherent in the nature of the object.   My estimation is that the European banks have a rather large demand for liquidity in Euros right now, but they just don’t want to risk sovereign defaults.  They much prefer cash Euros to 5 year greek bonds, even though they would love the extra return.

Still, there is little doubt the Eurozone will survive:

At the end of the day, the Europeans will save themselves, with the measures outlined above – only because there will be no other way to avoid wasting 60 years of political unification.  But this action won’t “save” everyone; one or more countries will be forced out of full eurozone membership (although they will likely keep the euro as the means of exchange).  And the costs to everyone involved will be large and largely unnecessary.

This is Simon Johnsons view, and not mine. But it is close to my view.  I think any countries that are part of the core Eurozone will be fine – well, not fine, but they will not get kicked out, and they will not default soon. Due to the presence of a fix that kinda sorta works and a lengthy political process, the Eurozone will stumble through, thinking it is about to fall over a cliff while walking in the middle of an empty Best Buy parking lot.  Because the temporary fix works “ok”, The long term fix will not be nearly as costly as Simon Johnson imagines.

The Eurozone will take the steps Mr. Johnson outlines, but the group of core countries will be larger than Mr. Johnson thinks today.

The bandaid fix of the ECB buying debt can work forever as long as spending is contained enough to cause only moderate inflation.  And spending is low, so inflation pressures will be contained.  So the immediate pressure is off the Eurozone, and they can work slowly and get the integration done over a period of years.

It is like they cured the disease, but do not know they will be well in a few months.  Think about this from the ECBs view – which is also the view of the Bond Vigilantes.  They believe these purchases create inflation and demonstrate the insolvency of the nations, so of course they think the situation is not tenable in the long term.

So here you have a situation where the Eurozone adopted a process that can stave off the worst parts of the crisis -immediate default – forever but does not know this to be true!

Then, look at the political process for Europe.  Slow.  Slow.  Slow.  They do not, and will not act quickly.  Not only that, but I do believe that Germany and France have come to an agreement to bailout the Eurozone overnight if things get really bad, but they just haven’t publicized it yet, because they want their currency to remain weak as long as possible.

As long as there is no reason to announce a deal, a deal will not be announced.  As long as the ECB continues to buy debt, there will not be a solvency problem, so there is no reason to announce a deal.

All of this points to a situation where the next 12 months are fun to trade – lots of short term volatility, combined with a constant threat of panic, and a clash of titans, with the opportunity to bash government bureaucrats over and over again for inaction.

The EURUSD trade has been a sideways trade due to holiday markets.  But with the new year, I am starting to see people recognize the fact that the Eurozone crisis is really just a few countries playing up the threat of default so the Euro remains weak.  Simon Johnson is one, but the astute Macro Man is another.

Once the idea that this crisis is solved begins to take hold, watch out 1.6000


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