Why the European Central Bank Will Not Print

The following appeared in Hussman Funds on 11-21-2011.
Over the past week, we’ve heard all sorts of propositions that the European Central Bank (ECB) “must” begin printing money to bail out Italy and other countries, because “there is no other option.” There are three basic difficulties with this idea. The first is that ECB buying might help to address immediate liquidity issues of distressed European countries, but it would not address long-term solvency issues, and would in fact make them worse. The second is that the ECB, under existing European treaties, has no such authority, and the prohibitions against it are very explicit. Changing that would be far more difficult than many market participants seem to believe, because it would require an explicit and unanimous change in the EU Treaties that AAA rated countries such as Germany and Finland vehemently oppose. The third difficulty is that even if the ECB was to buy the debt of distressed European countries with printed money, the inflationary effects would likely be far more swift than anything we’ve seen in the United States. This would not “save” the euro, but would simply destroy it by other means.

John P. Hussman of Hussman Funds is well known for his impeccable financial research

Investors are not likely to be treated with a “surprise” announcement that the ECB is going to expand its purchases of distressed European debt. Any significant ECB intervention would likely follow a formal revision of EU treaties that trades greater ECB flexibility in return for more centralized fiscal control.
Let’s cover these points individually.
Liquidity versus Solvency
First, it is important to keep in mind that while ECB buying of distressed European debt can address short-term liquidity problems (the need to roll over maturing debt as it comes due), it does not address the long-term solvency problems in these countries (the fact that they are mathematically unable to make good on it because the debt violates the no-Ponzi condition ).
A central bank works like this. It buys some amount of government debt, and pays for it by printing currency (or bank reserves). That initial purchase essentially represents free revenue to the government, since it gets to buy goods and services in return for costless pieces of paper, and the income from the bonds held by the central bank is transferred back to the government over time. The central bank can exchange maturing bonds new ones, or change the composition of its portfolio in other ways, but if it doesn’t increase the size of its overall portfolio, no new “base money” is created.
Rest of blog here.