ECB President Mario Draghi is the toast of European intellectual and political circles these days for having slain the economic dragons that were stalking the EU. These dragons are grotesque amounts of debt that are swallowing up economic growth in both individual countries and the entire European Union. Having taken the mantle from his timid and ineffective predecessor Jean-Claude Trichet, Mr. Draghi has adopted a series of dramatic, unconventional monetary policies that for the moment have pulled the EU back from the brink of total economic collapse.
First, Mr. Draghi - with the muscle of German Chancellor Angela Merkel behind him - was able to broker a second bailout deal for the hopelessly insolvent Greek state. While Greece still defaulted in everything but name, it was a managed default that did not disrupt financial markets. Of course, Greece's failure to repay its debt was one of the most anticipated events in capital markets history, but it still could have resulted in a market free-for-all had it been handled poorly.
Simultaneously, Mr. Draghi engineered the €1 trillion LTRO program that provided the insolvent European banking system with the liquidity and capital it so desperately needed. The LTRO rivals any of the rabbits that the inventive chairman of the United States Federal Reserve, Ben Bernanke, has pulled out of his hat to deal with the financial crisis and assures Mr. Draghi a prime place in the quantitative easing Hall of Fame. Of course, most of the new Euros created out of thin air by the ECB ended up either being redeposited right back into the coffers of the ECB or used to purchase more distressed sovereign bonds, but at least the banks that borrowed this 1% money could pretend they were solvent for another day.
Like a surgeon charged with saving the life of a dying patient, Mr. Draghi succeeded in designing a radical new cure that let the patient live a little longer. The question that now must be asked, however, is whether in the long run this cure will be worse than the disease.
This medical analogy is very appropriate in evaluating what Mr. Draghi has done. Take the example of a patient suffering from a serious infection. If the infection goes untreated in its early stages, it will likely become more serious and even life-threatening. At that point, it will require a far more radical treatment regime that, if successful, may leave the patient alive but also extremely weak and suffering from severe side effects (even permanent ones). Earlier treatment not only would have increased the odds of survival but reduced the toll that the treatment took on the body.
Economies are also complex living systems. Economic imbalances such as sovereign over-indebtedness that are not addressed in their early stages end up growing more severe to the point where they can threaten a country with insolvency. If the problem is not addressed early on, it will continue to grow until it becomes a far more extreme condition. At that point, far more radical remedies are required such as the severe austerity measures seen in countries like Greece, Portugal, Italy and Spain today. The side-effects of such cures are extremely painful and lead to other maladies such as poverty, social unrest, higher unemployment (especially among younger workers), and a loss of confidence in the political system. Not only is the mountain of debt that needs to be repaid that much higher, but the country's economy and political structure are left with permanent scars that can take generations from which to recover. Had the problem been addressed earlier, less painful policy changes could have returned the economy to health without damaging the body politic so severely.
This is the situation facing Mr. Draghi and the EU. In three years, when the banks that gorged out on the LTRO are due to repay the €1 trillion they borrowed, they are unlikely to be in a position to do so. They will have been operating in a recessionary European economy that will have not afforded them sufficient opportunity to earn enough of a profit to restore their balance sheets to health and repay these new debts. Accordingly, the most likely scenario is that these banks will ask the ECB for more time to repay these loans, resulting in the ECB balance sheet remaining bloated for years to come. It is therefore necessary to view the ECB's commitment as much longer than merely three years, which raises important long-term questions about the health of the Euro currency (hint: it will drop in value versus virtually every other currency in the world and especially against the value of gold) as well as the future level of interest rates (hint: they will remain very low).
Moreover, it is questionable whether the LTRO will do anything to truly return European banks or the European economy to health. First, as noted above, little of the LTRO money is ending up in the economies of the banks who borrowed it. Rather than being loaned to businesses that could create jobs and economic growth, they are being used to bolster weak bank balance sheets. This does nothing to expand the European economy. Second, more than mere liquidity schemes are required to return European economies to health. The LTRO will accomplish little unless accompanied by substantial labor, tax and fiscal reforms that can reignite productive economic growth. We are starting to see some signs of these reforms in some countries like Italy, where Premier Mario Monte is taking bold steps to change the country's rigid labor laws. This is a promising beginning but it is only a beginning. Europe has to make up for years of anti-growth policies that have contributed to its current crisis. As it faces a future of higher indebtedness and slow growth, individual countries and the EU must both hasten to adopt measures that will remove barriers to growth before the holes they have dug for themselves sink too deep. This means taking on entrenched interests such as labor unions and convincing them that their opposition to change is nothing less than suicidal. You can only commit suicide a certain number of times before you are really dead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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