Hussman Weekly Market Comment: Why the ECB Won't (and Shouldn't) Just Print

Here's something to think about. When we look at any stream of payments, the value is based on the whole long-term stream, not just the benefits received in the first few years. Those of you that are familiar with the dividend discount model, for example, know that the bulk of the "value" of a stock is not in the near-term cash flows the stock will throw off in the first few years, but in the very long-term "tail" of those cash flows (or equivalently, the terminal value expected in a buyout). Well, the same is true for a currency. Even if the Federal Reserve creates a massive amount of currency, it will not be inflationary provided people are absolutely convinced that the dollars will only hang around for a short period of time. If they ever become convinced that the new dollars are permanent (and especially if there is not an ongoing credit crisis to create safe-haven demand), the marginal value of each individual dollar would decline, and inflationary pressures would emerge.

From this perspective, it should be clear why the Federal Reserve's tripling of its balance sheet has not resulted in near-term inflation. There is significant demand for the U.S. dollar as a safe-haven currency, the creation of dollars is still viewed as temporary, even though the Treasury is still bailing out Fannie and Freddie in order to make the mortgage securities held by the Fed whole. The problem for the Fed will emerge in the back half of this decade if (and I suspect when) it becomes clear that there is no easy way for the Fed to disgorge its balance sheet without causing disruptions in an economy where the U.S. debt/GDP ratio will then be well above 100%. At that point, the dollars that the Fed has created may be looked upon as more permanent than the markets bargained for, and we are likely to see inflationary pressures. For now, however, we continue to expect only modest near-term inflationary effects from the Fed's actions, despite being reckless and misguided in a broader sense.

Against this backdrop, consider a situation where the European Central Bank begins to print new euros in order to purchase the debt of distressed European countries that are deeply indebted and likely to become more so (barring a major restructuring of their existing obligations). In this case, would people be likely to view the newly created euros as temporary or permanent? Would people be likely to seek the euro as a "safe haven," or would they seek the relative safety of some other currency? For my part, I am convinced that a move to buy distressed European debt by creating euros would be seen as permanent money creation, and that far from seeing any safe-haven demand for euros, we would instead see a flight from the euro. As a result, European inflation would predictably accelerate.

The bottom line is this, the call for massive ECB purchases of distressed European sovereign debt is not simply a call for a liquidity-providing intervention, but is an attempt to address a solvency issue. Liquidity issues can often be addressed through temporary increases in the stock of money, but to address solvency issues, you have to print permanent money. A memorable instance of permanent money creation as a means of financing budget deficits was in 1922, when Germany (saddled with war reparation obligations that violated the no-Ponzi condition, and responding to an invasion of the Ruhr by France and Belgium), began printing money in order to keep paying striking workers in the Ruhr even though they were not producing goods and services. The shift to printing money triggered an immediate flight away from the German mark. The resulting hyperinflation is well-remembered by the German people even if the rest of the world has forgotten.

There are strong legal restrictions among the EU nations against solvency operations by the ECB, and even if one believes that this is inevitable, the chance of the ECB deciding to abandon EU Treaties on its own is zero, in my view. The main thing to look for, if the ECB is to expand its purchases of distressed European debt, would be a solid effort to impose centralized control on the fiscal policies of the individual European member states. This will be a painstaking process, subject to unanimous approval by EU member states. But I strongly doubt that we will see significant ECB intervention without a formal revision of EU treaties that trades greater ECB flexibility in return for more centralized fiscal control.