Trichet Delivers: ECB Hikes Its Interest Rate!

The European Central Bank raised its policy interest rate by 25 basis points this morning and, I believe, changed the game.

Mr. Trichet, president of the ECB, delivered on his promise initiatlly given in March.

To me, this is a “tipping point”, even though the Bank of England kept its policy rate constant. Other central banks around the world have been raising their policy rates over the past year but no “Western” central bank had followed.

Now, the “West” has followed and this alters, not the outlook for interest rates, but the timing of future increases.

There are three areas one needs to focus on within the current environment.

First, keep an eye on what goes on in the Eurozone in terms of country “bailouts” and the potential re-structuring of the sovereign debt within the nations of Europe.

It was not a coincidence that Portugal asked for help the day before the meeting of the ECB. Portugal has lots of debt coming due this year; its credit rating has gone through several reductions already this year; and the country is without a government and facing an election. Even Portuguese banks were saying that they would not buy anymore debt issued by the government of Portugal.

Facing a “new” attitude in the capital markets and rising interest rates, what is substituting for a government in Portugal had to act. In essence, the IOUs were coming due.

And this means, I believe, that the IOUs are going to be collected elsewhere within the Eurozone. The day of reckoning has been advanced. People are going to have to do something now.

Second, watch what European banks are doing and are going to do. On Wednesday, two European banks announced their plans to raise new capital. The total to be raised amounts to about $19 billion and brings the total capital raisings announced this year by European banks to almost $36 billion.

Again, I don’t think that the timing of the announcement, the day before the ECB raised its interest rate, was a coincidence.

Furthermore, the Spanish government this week stepped up efforts to get its “healthy” banks to buy up a good portion of its “savings” banks in an effort to shore up Spain’s threatened banking industry. With Portugal now seeking help, a greater focus is going to be placed upon the fiscal health of the Spanish government and its banking system. Spain is going to move because it appears as if it may be “next in line”.

In addition, there still are the results of the recently applied “stress” tests on the commercial banks of Europe. Two things here: there is the question about how valid the tests are; and there is the response of the banks, themselves, to the results of the tests.

The European “stress” tests are already being questioned relative to whether they are strong enough to really be anything but a subject of jokes. If the tests are too weak to prove anything, then the credibility of the European regulators will suffer a serve blow at a very crucial time. This will not raise the financial markets confidence in the European banks and the European banking system.

The European banks may have to “act on their own” to overcome this loss of regulatory credibility. The way to do that? The banks can raise a significant amount of capital on their own and take the whole question of capital adequacy out of the hands of the regulators. This may be a part of the strategy of the European banks that are now raising capital.

Third, continue to observe the behavior of the United States dollar in foreign exchange markets. My guess is that this move by the ECB to raise its interest rate will cause further erosion of the value of the United States dollar in foreign exchange markets. This move may not be immediate, but will persist over time.

By raising its policy rate, the ECB may be forcing Europe to get its act together and resolve some of its solvency and governance issues. The movement by the Portuguese is just a starting point. The movement of the banks adds momentum to the process. If this action truly brings events “to a head” then, I believe, everyone will be better off for it.

But, if Europe begins to move in the right direction, what is in store for the United States dollar?

Europe moving to resolve some of its issues will only result in more pressure for the value of the United States dollar to decline. And, this decline will only provide additional evidence that the international community has little confidence in the current leadership of the United States to really address its fiscal (and monetary) problems.

The question then becomes…will this change the nature of the discussion within the United States?

Will this twenty-five basis point change in the policy interest rate of the European Central Bank serve as anaction that creates the “tipping point” for the direction of economic and fiscal policy in Europe and the United States?

I’m sure that the wiley Mr. Trichet would like to see this happen.

I’m not sure that the former professor of law from the University of Chicago and the former chairman of the Princeton Economics Department would agree.

For Mr. Trichet, the New Rules are "Insufficient"

The European sovereign debt unpleasantness continues.

Muddle, muddle, muddle…

The European finance ministers want automatic sanctions against EU countries that violate the debt levels assigned to the countries…

That is, unless a country has enough allies to be able to avoid the sanctions if they break the rules.

Jean-Claude Trichet, president of the European Central Bank, states that the new rules put into place on Tuesday are “insufficient.”

The next step in the application of these rules involves the approval of the European Parliament. The feeling is that this body, given the position taken by Mr. Trichet, will push for tougher rules.

We’ll see.

Meanwhile, back at the ranch, Moody’s Investors Service downgraded Portugal’s long-term government bond rating.

And, the finance minister of Greece, George Papaconstantinou, indicated that Greece might need additional aid beyond what was in its initial bailout which came in 2010.

Interest rate spreads on European government debt over German government debt rose again yesterday after spreads had fallen on Monday after reports from the weekend meeting of the finance ministers was released.

Financial markets just don’t seem to be convinced that the problems that exist within the eurozone are being faced. Government officials seem to want to return to a previous world and will try any band aid they can construct in order to get things “back to the past”.

At least two governments within the European Union are going to have to write down the value of their debt. Maybe there might be two more that will have to do the same thing.

Then, these nations are going to have to severely limit their future budget deficits.

After this, some of the peripheral nations are going to have to bring their economies into the 21st century. This is going to be the hardest part of this exercise.

The point here is that just getting government budgets back into greater balance is not going to do resolve all the issues of the European Union. One of the fault lines that Raghu Rajan writes about in his award winning book “Fault Lines: How Hidden Fractures Still Threaten the World Economy,” is the one that exists between those eurozone countries that are growing rapidly and those whose growth is lagging behind because they are still trapped in the 20th century.

So, in addition to just the fiscal issue, there are structural issues that some nations are going to have to deal with, and, given the protests and riots we have already experienced, it is obvious that such changes are going to be painful. But, the future of the European Union, as it now stands, depends upon this effort.

How can the European Union hold together when these social, as well as economic, issues that are so divisive must be dealt with? If the budget constraints are held to, the governments that face the greatest amount of change are not going to have the “deep pockets” needed to resolve the social unrest that might result. How can the needed change take place without a lot of economic “safety nets” in place, especially in Europe?

In my view, Europe has a long way to go and the sovereign debt problem is just a bump along the road. But, since the “people” issues connected with making these peripheral countries competitive in the 21st century are so important, the debt of these troubled countries should be written down so that the governments of these countries can get their fiscal houses in order.
Then, these governments can deal with the “safety net” issues that they will be facing.

Trichet is correct, what has been done is “insufficient”, but there is much more to the situation than that.

Trichet: It's All About A Strong Euro

Jean-Claude Trichet, the President of the European Central Bank (ECB), made headlines toward the end of last week by suggesting that the ECB might have to raise its major interest rate in April.


This suggestion raised quite a bit of controversy and also helped the Euro to rise, briefly, to more than $1.40 per Euro. It also, some said, set the stage for the weekend in Europe and the upcoming discussions about fiscal affairs in the eurozone countries. (http://seekingalpha.com/article/256255-meanwhile-back-in-europe-a-view-of-the-ecb-inflation-and-other-matters)


Trichet has been as hardnosed as anyone in recent years about keeping inflation in check. And, since 2003 when he became President of the ECB, he has been adamant about maintaining an inflation target as the primary objective of the central bank.


In doing so, he has been relatively successful in allowing eurozone economies to expand while keeping the Euro strong, especially against the United States dollar.







In this chart we see an almost steady climb in the dollar/euro exchange rate from about 2002 until late 2008 when the financial markets began to collapse and there was a “flight to quality” toward the United States dollar.

As market participants moved back into “risk” in 2009 the dollar/euro exchange rate began to rise again, roughly reaching $1.50 per Euro. The sovereign debt crisis in the eurozone resulted in another drop in the exchange rate but the Euro began to rise again once Fed chairman Bernanke started talking up his plans for Quantitative Easing, Part II, for the Federal Reserve in late August 2010.


The strength of the Euro, especially against the United States dollar, should be seen as a source of pride for the President of the ECB. Trichet, a Frenchman, saw how upsetting inflation or the threat of inflation could be in international financial markets when he served in the Treasury Department in France during the time that Francois Mitterrand was the President of the French Republic.

Mitterrand was a socialist and who came to power in 1981. Early in his first term, Mitterrand followed a radical economic program, including nationalization of key firms. The economy developed a serious inflationary problem and money fled France causing a substantial decline in the French Franc. After two years in office, Mitterrand made a substantial u-turn in economic policies. In March 1983 he presented the so-called “Liberal turn”, in which priority was given to the struggle against inflation so that France could remain competitive within the European Monetary System.


The young Treasury Department official took note of this and applied the lessons learned when he became a Governor of the Banque de France, a Governor of the World Bank, an Alternate Governor of the International Monetary Fund and the President of the ECB.

Leading the European Central Bank is one thing, but the ultimate success of Trichet’s efforts to keep European inflation under control is also dependent upon the European Union (EU) getting its fiscal act under control. The sovereign debt issue and its resolution amongst the eurozone countries is crucial to the EU in keeping inflation under control and even whether or not the Euro will continue to exist.


The problem in the eurozone is that the limits or restrictions on independent sovereign nations to conduct their own fiscal policies have not been very effective. The leaders of the EU are going to have to reach some satisfactory solution to this problem or there will be continued attacks on the sovereign debt of the less disciplined countries and this will tend to bring with it attacks on the Euro.

In my view, the EU has two choices. It either moves toward the German model of conservative fiscal control of governmental budgets or it fails to bring sufficient controls on less-disciplined governments which, to me, is basically saying that the EU will err on the side of not offending anybody.


To err on this latter side is to seal the fate of the Euro. If one takes the “weaker” side, if one allows the less-disciplined to get-away with their lack-of-will, then the financial problems of the eurozone will continue and there will be a movement away from the Euro. Over time, the value of the Euro will slowly deteriorate. The Germans will not remain in such a union and the Euro will become “legacy.”

Trichet hopes, I believe, that the Germans will prevail in determining the fiscal parameters of the European Union now being discussed. This, to me, is the only hope for the Euro surviving in the longer run. In this, the Germans win…which a lot of people in Europe…and elsewhere…don’t really want to see.

Ultimately, however, the more fiscally prudent nation will prevail whether or not the Euro does. I believe the Germans don’t want the Euro to become history, but they are not willing to sacrifice their economic strength and benefits to live with the excesses of other governments. It is good to be economically strong!


Thus, to Trichet, it’s all about a strong Euro. He has done his job in setting the stage for the continuing discussions within the EU over the future of eurozone cooperation, fiscal policies, and debt restructuring. For the eurozone to be a strong player in the global economy in the future, the EU must have a strong currency. Trichet has done his job in an effort to achieve this goal.

Greece and Insolvency

A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.

Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.

Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.

Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.

But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)

By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.

There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!

The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.

Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.

Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.

Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.

The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.

It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.

Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.

The Piper eventually has to be paid.

The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.

This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?