Monday, May 17, 2010

Hussman Weekly Market Comment: Two Choices: Restructure Debts or Debase Currencies

In the end, as I've argued repeatedly over the years, monetary policy is only as good as fiscal policy. A central bank does not have wealth of its own. It is a zero-sum entity that can only enrich those from whom it purchases debt by debasing the relative wealth of people who hold the existing stock of currency. If a government insists on running deficits, engaging in wasteful spending, and dissipating public resources to bail out private bondholders, it has to find somebody willing to buy its debt. If it does not, the central bank buys it, and dilutes the currency by doing so. The situation is particularly insidious when the central bank buys low-quality debt, because there is no taxing authority behind it to provide a basis for confidence in the currency.

The Euro-area has a special problem in this regard, because the bailouts represent clear country-to-country transfers of wealth, and risk creating inflation for all the members of the European Community in order to defend the deficit spending of countries that simply do not have enough flexibility to cut those deficits. Greece in particular is likely to experience so much loss of output that it will most likely lose on the revenue side much of what it cuts on the spending side. For that reason, the deficits are likely to come down much slower than expected. Germany, with its particularly strong aversion to inflation, is unlikely to accept the costs for long.

It is difficult to project the timing and events by which all of this will be resolved, but I increasingly suspect that the (relatively) stronger Euro-area countries will reject the prospect of providing continuing subsidies and accepting growing inflation risk as the cost of keeping deficit-prone member countries under the euro umbrella. In short, I don't expect that Greece or Portugal (Spain is more uncertain) will ultimately remain part of the euro.

At the point that Greek and Portugese debt has to be restructured (which seems inevitable given the negative revenue effects of austerity measures), departure from the euro will give these countries a better ability to depreciate their currencies to a level that re-aligns internal wages and prices with competitive levels. This will be a less disruptive solution than having to force - as austerity measures do - a massive internal deflation through wage reductions and spending cuts. The unpleasant alternative is to hold the line on wages and prices within Greece, Portugal and other high-deficit countries, and suffer inflation throughout the entire Euro-area as those debts are monetized. The only other alternative, which does not seem at all likely, is that other Euro-area countries will accept ongoing country-to-country transfers in order to finance the deficits of their neighbors.

Without a central taxing authority, the goal of a common European currency can only survive if the participating countries obey a rule that strictly controls the deficits of individual countries. Without that, the whole system is compromised. It should not be difficult to recognize that the confidence in any currency is tied to the confidence in the assets which stand behind it, and associated confidence in the restraint of fiscal and monetary authorities. The bureaucrats in both the U.S. and European central banks have chosen to betray that trust. It's fascinating that they seem genuinely surprised when their generosity with other people's wealth (and their assurance of greater betrayal) is met with contempt. While I expect that the euro will survive by the coordination of its stronger members, it risks being debased by the unwillingness to accept debt restructuring sooner rather than later.