Daily Archives: October 21, 2011

What should Mario Draghi do?

The Economist recommends the following:

  • Facilitate an orderly Greek default
  • Support other Eurozone countries in the bond markets through necessary purchases
  • Cut interest rates

I think that the first recommendation is a no-brainer.  The Greeks are hopelessly over-extended and will never be able to meet all their debt obligations at face value.  It is also unreasonable for Greek debt-holders to expect to not take losses on their investments.  No one likes losing money, but investments are inherently risky.  These risks are typically factored into the cost of the investment.  Risks associated with Greek debt may not have been factored in correctly, but there the fault lies with the ratings agencies and the investors themselves, who obviously did not do their due diligence.  Yes, we understand that independent due diligence is expensive and time-consuming, but why should tax-payers now recompense investors who cut corners?  The tricky bit will be in ensuring that the default is orderly.

The second recommendation should work towards preventing risk contagion from destroying other vulnerable economies.  It is a commendable action in the sense that it aims to prevent further defaults and to protect citizens in vulnerable economies from the depredations of financial markets.  It is problematic because it implies the use of taxpayer money to placate market sentiment.  It was market over-optimism and financial chicanery that contributed to the debt overhang in the first place.

The third recommendation is geared towards providing monetary stimulus to a spluttering European economy.  Rates are already low at 1.5%.  Europe is already in a liquidity trap.  I don’t see an interest rate cut as being useful, but then, on the other hand, it can’t hurt in the short run.  In the long run there may be inflationary pressures, but given the weakness of aggregate demand and the timidity of the investment community, this is not a foregone conclusion.  We may see long term deflationary trends a la Japan instead.

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