PIIGS update

These charts illustrate the macro state of financial affairs in the Eurozone. As the top chart shows, 2-yr Eurozone swap spreads are still very high, almost as high as they were at the peak of the 2008 financial crisis, when the world confronted the perceived threat of a global financial market meltdown, several years of deflation, and a global depression. The bottom chart, on the other hand, shows that the risk of sovereign defaults has declined significantly in the past month or so, particularly in the case of Italy and Spain, the two largest PIIGS debtors. (The likelihood of a Greek default, of course, is extremely high, and it would surprise no one if the country actually did default.)

So the Eurozone banking system is still hanging by a thread, to judge from the level of swap spreads, but the outlook for the Eurozone's larger debtors has improved measurably—an apparent contradiction. One plausible explanation for this is that the ECB's massive balance sheet expansion in the past week or two (see chart below, which is measured in trillions of dollars) has artificially depressed Italian and Spanish yields, but has not done anything to address the fundamental problem of the Eurozone, which is that too many governments have borrowed and spent more than they should have, and on unproductive activities. Thus, Spanish and Italian debt prices have improved, thanks to ECB purchases, but the whole Eurozone financial structure, as reflected in very elevated swap spreads, rests on very shaky bedrock.

It makes sense that the ECB can't fix the Eurozone's problems simply by buying the bad debt of struggling PIIGS countries. The ECB can, however, buy time for the system to fix itself, and there are signs that the PIIGS countries are beginning to take needed action to reduce their spending. But in the meantime, what about the consequences of massive central bank balance sheet expansion? Doesn't that just compound the problem by introducing the risk of hyperinflation?

Not necessarily. As with the Fed's balance sheet expansion, the vast majority of the bank reserves that have been "created" in the process of accumulating Treasury, MBS, and sovereign debt are still sitting idle on the central banks' balance sheet in the form of excess reserves. In essence, all that has happened is that the central banks have exchanged bank reserves for bonds—the rough equivalent of transforming risky bonds into risk-free bills. The market has been happy to unload trillions of dollars of bonds for bank reserves, and this means that a huge share of the burden of default risk of PIIGS debt has been shifted to the ECB. It has also satisfied the huge demand for safe-haven assets.

But if the ECB's new assets end up defaulting or being written down significantly, this will erode the ECB's balance sheet and impair its ability to defend the value of the Euro. How would that work? Presumably, at some point the world will become less fearful of an economic and/or financial market collapse, and the demand for money will decline. A declining demand for money is equivalent to an increased desire to borrow money, and the existence of trillions of bank reserves gives banks a virtually unlimited ability to create new spendable money. Money supply expansion could become brisk and eventually undermine the value of the Euro; the ECB would ordinarily avoid that by withdrawing reserves from the banking system, and that would be achieved by selling off its accumulated balance sheets assets. Of course, if those assets have dwindled due to defaults, then the ECB couldn't fully reverse its reserve injections, and the Eurozone could end up with a huge surplus of money.

For the time being, there is no sign of any unusual expansion in the Eurozone money supply (the chart above uses the latest data available, as of 10/30/11). M2 in both the Eurozone and in the U.S. has been growing at slightly more than a 6% annualized rate for a long time.

So although the situation is far from ideal, it is neither catastrophic nor beyond hope.