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Europe's Real Problem? Deflation

European markets experienced a rare moment of respite yesterday, but this was just a pause in the panic. No comprehensive solution to the continent’s sovereign debt woes seems to be near at hand.

Why can't policymakers and market participants come to a consensus about what needs to be done? I suspect the problem is a serious misunderstanding about what is actually happening in Europe and why it will have dire economic consequences.

Europe is experiencing a stealth monetary contraction, which is another way of saying it is undergoing massive deflation .

This might sound odd to many readers. The voices out of the European Central Bank all sound the alarm of inflation . And it’s not just the central bankers. Journalists too start clanging on about inflation whenever a serious plan for addressing Europe’s problems is proposed.

“The European Central Bank is under mounting pressure to take a leaf out of the Federal Reserve's 1940s playbook by setting caps on government bond yields, a move that may stoke inflation,” John Glover at Bloomberg wrote recently.

What the inflationistas are missing is that Europe is actually suffering from a profound contraction of its money supply. This contraction is crippling the banking system and will bring the economy to a grinding halt if it is not allieviated.

It’s easy to miss the contraction of the money supply because it involves a destruction of financial assets that we do not usually think of as “money” but that, in fact, operate as money — or did until relatively recently.

The fundamental characteristic of modern fiat money — as opposed to commodity-based money under a gold standard — is that it serves as a medium of exchange. This means dollars or euros, for example. Basically, the local currency.

Within the banking system, however, other financial assets also serve as money. These assets can be used to meet margin calls, collateralize obligations, and make payments. U.S. Treasury bonds are the most obvious example of this kind of money-equivalent financial asset. The U.S. government recognizes the equivalence of Treasury bonds and dollars within the banking system by not requiring banks to hold any reserves against the bonds. They are counted as “cash or cash equivalents” on balance sheets of U.S. public companies.

Over in Europe, sovereign debt issued by euro zone nations also served as a money-equivalent inside the banking system. Banks were not required to hold reserves against sovereign debt. They used them as collateral for obligations, and made inter-bank payments with sovereign bonds. The bonds were, in short, as good as euros.

When the markets turned against nations like Greece and Italy, the cash-equivalency of their bonds came into doubt. It was obvious that they could lose value, and quite rapidly. The debt could no longer be used as collateral, except at extreme discounts.

The discounting of sovereign debt, then, meant that there was less money in the European banking system. If a one million euro bond previously held as a money-equivalent is now worth just 600,000 euros, the holder has lost 400,000 euros. Multiply that across the banking system, and you have millions of euros of money-equivalents simply vanishing.

It is exactly as if some paper-eating plague just started rotting physical euros. The money supply of Europe is vanishing.

This is not the first time this has happened. In the U.S., triple-A rated mortgage-backed securities also served as cash-equivalents within the banking system. They weren’t quite as good as cash — but they were very close. Reserve requirements were minimal, they could be used as collateral, and they were a medium of exchange within the banking system.

When the bottom fell out of the housing market, top-rated mortgage backed securities lost their ratings and the confidence of the market.

This represented a loss of money-equivalents within the banking system. It was a stealth monetary contraction.

The Federal Reserve acted by replacing the lost money-equivalents with actual money. Many thought the expansion of the Fed’s balance sheet would be hugely inflationary. When inflation didn’t come, pundits were left sputtering about it being just over the horizon or some other nonsense.

The reason the feared inflation didn’t arise is because the Fed was not expanding the money supply. It was replacing lost money-equivalents with new money. Far from being inflationary, the Fed’s program was probably mildly deflationary because it did not actually replace the lost money-equivalents with new money dollar-for-dollar.

This is why fears of ECB action on European debt are so badly misplaced. Europe is experiencing a Great Contraction — the decline in the supply of its money equivalents. The size of this contraction is stunning. It includes the entire bond markets of Greece, Italy, Spain, and Portugal . Before long, it will include many other nations.

The ECB’s central — perhaps its only mission — is monetary stability. It cannot perform this mission, however, because it doesn’t properly understand that it is overseeing a monetary contraction. Unlike the Fed in 2009 and 2010, the ECB is refusing the replace lost money-equivalents with new euros.

This is what’s gone wrong in Europe. A monetary contraction is still being called a “sovereign debt crisis” and a banking crisis. What we really have is a deflationary crisis.

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