STAFF NEWS & ANALYSIS
ECB Hikes Rates, Crushes Spain?
By Staff News & Analysis - March 08, 2011

Flat-Earth European Central Bank misreads oil spike again, and kicks Spain in the teeth … The European Central Bank has once again risen to the bait. Faced with an oil supply shock that deflates incomes, it plans to tighten the vice yet further with a knee-jerk rate rise in April. One-year Euribor rates – the rate used to price most Spanish mortgages – jumped 14 basis points to 1.92pc after ECB chief Jean-Claude Trichet (left) uttered the code words 'strong vigilance'. The demarche is reckless, politically-motivated, and risks causing yet another spasm of the EMU debt crisis. If recovery proves to be more fragile than it looks – vulnerable to a fiscal squeeze in the West and a credit squeeze in the East – this ECB error will have global ramifications. – UK Telegraph

Dominant Social Theme: It must be done. The ECB is a hawk when it comes to inflation.

Free-Market Analysis: Only a month or so after predicting that Spain would survive its sovereign debt crisis, Britain's best mainstream financial journalist, Ambrose Evans-Pritchard has been steadily backpedaling. It's kind of amusing actually. There are journalists who are optimistic by nature and those who are realistic/pessimistic. Evans-Pritchard falls into the latter category. Occasionally he will write something optimistic about the world scene but even when he does, it doesn't last very long. His morose, writerly persona reasserts itself.

In this article, (excerpt above) he is back to doing what he does best, warning the world about the excesses of EU monetary policy and its downright incompetence. In this case, he wishes to point out that the ECB is reacting to higher oil prices by raising rates. The idea is that by reducing the availability of money, one may combat the rise in oil prices, thus stifling nascent price inflation. From Evans-Pritchard's point of view this is a wrong prescription. And he is absolutely correct. Inflation is a monetary phenomenon. It has to do with the amount of money in circulation and the willingness of people to increase its velocity. It has little or nothing to do with exogenous shocks like rising oil prices based on color revolutions abroad. One might just as well spit into the wind. Here's how Evans-Pritchard explains it:

The ECB's governors might usefully study Systematic Monetary Policy and the Effects of Oil Price Shocks, a seminal work in 1997 by a Professor Ben Bernanke of Princeton. The reason why such shocks often lead to slumps is because policymakers make a hash of it. "The majority of the impact of an oil price shock on the real economy is attributable to the central bank's response, not the inflationary pressures engendered by the shock," wrote Bernanke. No doubt ECB governors need to prove their hawkishness after Bundesbank chief Axel Weber walked out of the Eurotower in disgust, more or less stating that he did not wish to take over a body that had departed so far from orthodoxy, and succumbed to political pressure by purchasing the bonds of bankrupt states.

We are not quite sure why Evans-Pritchard chooses to quote Bernanke – who has all but ruined what is left of the American economy – but it goes to the heart of a larger issue regarding his analysis and the analysis in general of those who analyze central banking without suggesting an alternative. Evans-Pritchard has made it clear that he does not believe in free-market money (though what he DOES believe in is an open question). But like many other journalists and economists, the game to be played has to do with criticizing the policies of central banking and then suggesting alternatives. The idea is that if central bankers were only SMARTER or WISER then many economic problems could be averted.

This begs the question though: Why is it that central bankers are NOT smarter and wiser? And the answer is because no one is more intelligent than the market itself. The idea that individuals, even knowledgeable ones, can fix the supply and value of money artificially without letting the market itself decide is abysmally flawed. It is responsible for most if not all of the economic ruin that afflicts Western societies.

Pritchard's point in this case is that with so many European economies perched on the proverbial knife-edge, even a modest rate increase can further raise borrowing costs, making it increasingly mathematically impossible for the Southern PIGS to pay their sovereign debts. He may be incorrect about the necessity of central banking generally but the ramifications of an ECB rate hike are not theoretical.

Spain is now being whacked again. One-year Euribor rates jumped 14 basis points to 1.92pc within hours after ECB chief Jean-Claude Trichet uttered the code words "strong vigilance". As the ECB knows, this is the rate used to price most Spanish mortgages. Homeowners due for rescheduling in March will take the hit immediately. Fresh waves will follow each month, with knock-on effects for banks and Cajas already grappling with record defaults. Fitch Ratings said on Friday that the financial system will need €38bn in fresh capital to right the ship. The Spanish might justly feel aggrieved, and judging by the comment threads of the Madrid press – "Put Trichet on trial", "Leave the EU immediately", "Create a currency for the South" – a vocal minority of Spaniards are going through their moment of EMU Epiphany.

We wonder how long all this is going to last. It seems that Europe is headed toward some sort of crisis, mostly brought on by the impossibility of resolving the North/South divide. It is simply impossible to have a single central bank and a single currency for dozens of countries without a political union. It is an acknowledged fact that the socialists who run the EU were of the opinion that when the inevitable crisis came, the pressure would lead to a closer political union. But this doesn't seem to be happening, or at least not fast enough.

British, French and German banks were not willing to write off loans to the profligate PIGS. Instead, they used the brute of the EU to impose "austerity" and punitive borrowing terms on Greece and Ireland in particular. Both countries would have been better off allowing their own banks to go under and then, somehow, leaving the EU in order to devalue their currencies. Alternatively, as a last resort, debt could actually have been repudiated though that would be a so-called nuclear option.

None of these options were put into play. The EU faces now an intractable fight between the stressed PIGS and Germany, which will not budge on issues having to do with shouldering more of the burden of Irish and Greek debt. In retrospect one wonders if the Eurocrats were overconfident about their powers of persuasion or if they misjudged the Germans in particular. The Germans give every indication that they will not budge. Even a socialist-corporatist like Angela Merkel cannot negotiate what she cannot control. She has been given orders by the political establishment and she dare not disobey; she cannot do so.

After Thoughts

We do believe, of course, that the "wild card" – the unforeseen factor – was the Internet itself. The Greeks and Irish alike are well aware that the EU at this point promises nothing but grinding austerity, higher taxes and a lowered standard of living. The Germans, equally informed at this point, are determined not to shoulder the burden of profligate PIGS. There is far more to worry about in the EU than an ECB rate hike, as destabilizing as that may be. The real issue is that the EU is approaching a place where there is no compromise between what the PIGS demand and what Germany is willing to tolerate. A moment of truth is emerging.

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