This morning’s swan dive in the euro stopped the Santa rally right in its tracks.
We have two questions: 1) Has the ECB shot its wad as the lender of last resort providing massive liquidity to the banking system and leaving little ammunition for the distressed sovereigns; 2) Will money demand remain stable in the eurozone as the monetary base explodes? That is, will the Germans keep their money in Europe?
As we’ve stated many times on this blog, monetizing debt that nobody wants is much different than quantitative easing in an effort to goose the economy. Furthermore, economists have yet to come up with a clear definition of money. As base money explodes in Europe the overall monetary aggregates can still decline as credit contracts. This can partially offset any potential down shift in money demand without causing inflation.
This assumes liabilities of the central bank remain in the system as they are in the U.S., in the form of excess bank reserves. If bond investors sell their bonds to the ECB, either directly or indirectly, and take their money out, Super Mario will have a problem.
Many competing economic theories are being tested in real time in the laboratory that has been forced upon the global economy since the bursting of the credit bubble. See here for an interesting debate on Ricardian Equivalence. Stay tuned.
(click here if chart is not observable)