Bullwinkle the Moose might call the $1 trillion euro intervention fund ‘antihistamine money’ since ‘it ain’t nothing to sneeze at.’
Give it to Henry Paulson, treasury secretary for George W. Bush, and he might think he had a bazooka in his hands. But just like Paulson’s ill-fated plan to keep Fannie Mae and Freddie Mac from going bust by promising Treasury support, this week’s much-touted European Union-IMF measures may not achieve success.
Should we in the United States really care about what happens “in a faraway country between people of whom we know nothing,” to use former British Prime Minister Neville Chamberlain’s memorable phrase? In a word, yes. Whether we like it or not, the success or failure of the euro as a multinational currency is of such importance to the world economy — and hence to our own — that we should care a great deal.
It is good to recall the failure of Credit Anstalt, Austria’s largest bank, in the summer of 1931. Deemed a sideshow to our own problems at the time, this bankruptcy ushered in a second, more difficult, phase of the Great Depression globally and led directly to Hitler’s coming to power in Germany two years later.
We don’t face analogous political chaos today, but the coming apart of the euro system would be a serious blow to our economy that still shows few signs of true recovery. It would make the Federal Reserve’s task of unwinding its enormous potential increase in the money supply even more difficult, and in the end it probably would bring down some major financial institutions.
The problem for the United States is that we really cannot do much.
The Fed did announce it is renewing arrangements to make temporary loans of dollars to the European Central Bank in exchange for euros. This adds to the ability of the European Central Bank to intervene in currency markets to keep the euro from falling to undesirably low values compared to the dollar.
Despite much rumbling in the blogosphere about a U.S. bailout of the euro, this is a small component of the effort. Moreover, while not done routinely, such swaps between central banks occur frequently and go both ways. On several occasions in recent decades, the Fed was on the receiving end of the favor. And there is no question that at some point the dollars will come back in exchange for the euros.
There is a legitimate question, however, over the source of the dollars. The Fed can simply create new dollars out of nothing to hand over for euros. But those euros will then be added to the asset side of a Fed balance sheet that is nearly three times as large as it was three years ago.
That is another way of saying that this temporary trade with the European Central Bank would further increase the potential quantity of money in the economy. That would boost the potential for inflation, already high, if banks actually start to lend rather than just sit on much of their deposits.
The Fed could “sterilize” this international operation by selling previously bought domestic bonds to reduce the domestic money supply by the exact amount that it increases dollars abroad. Richmond, Va., Fed President Jeffrey Lacker, among others, has called for just that. This is a good idea but small in importance relative to the question of the possibility of success of the euro-intervention initiative itself.
And that is largely out of our hands. Like most other economists, I am not optimistic. As myriad other commentators have noted, there is no long-term solution other than writing off a substantial portion of the public-sector and even private-sector debt in several euro countries. And that, in itself, would certainly roil world financial markets and economies. We are years from being through this.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.