It turns out a central bank can go bankrupt. No doubt you are wondering–as I did when I first heard about this–how can an entity which is able to print money at will go bankrupt? The answer is that they can only print one kind of money. If they accrue a bunch of liabilities in another currency, then when those come due they have to get that currency. One way to do this is to borrow it, which is to say to accrue additional liabilities in that currency. Another way is to print your own currency and buy it. The first way is usually preferable because the second tends to wreck your currency’s exchange rate. But what happens if nobody wants to lend to you in that other currency any more? Then you have to print money and try to buy it, which, as I said, wrecks your exchange rate. People seeing this happening may then refuse to sell it to you in exchange for your currency which they realize is likely to plunge in value. At this point you have no options but to default.
Now turn to mainland Europe. They created the Euro and the ECB knowing full well that it wouldn’t work with each country having independent fiscal policy. Now it is coming apart. The answer, as I have been predicting, is to create more centralized power over fiscal policy. In other words, now they are going to get the thing that the people didn’t want to begin with by giving them something else that was completely unsustainable without the first thing but while telling them that it was. Now they are faced with the choice between trying to unravel the Euro which would be painful and going deeper into centralized control which would be less painful–at least in the short run.
Dollar funding strains have increased in Europe as U.S. money market funds have pulled their lending to European banks on fears of exposure to the debt crisis. The banks need to finance foreign operations and liabilities denominated in dollars.
If the financial problems in Europe were only due to Euro-denominated debt, the ECB could fix it just by printing more Euros. But if it is denominated in another currency, like dollars, it is not so simple. This means that the bailout must come from outside. The first wave takes the form of cheaper dollar swaps. But this only serves to get European banks even deeper in dollar-denominated debt. It will not solve the problem.
The eventual solution will require one of two things. Either we (the Earth) return to sound money not controlled by government and central banks, or we create a world-wide monetary authority to bring them all and in the darkness bind them. It’s obvious which way we are heading. The IMF is being set up as the precursor to this entity.