Europe Wakes Up to Monetary Contraction

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The news that European banks will now be able to borrow euros for three-year terms by posting a broad array of collateral is the best sign so far the European Central Bank is recognizing that the continent is experiencing an extreme monetary contraction.

Until now, it appeared as if the ECB did not understand that it was facing a monetary contraction. It's officials seem to still be worried about inflation and hesitant to expand the supply of euros in the face of a crisis.

This posed a dire threat to the economies of Europe. Inside the banking system, European sovereign debt had lost its money-like quality. It could no longer be posted at anywhere near par for interbank borrowing. Some bonds couldn't be used as collateral at any price at all. The discounts on the bonds have the same effect as a fire inside a bank vault would have — the banks suddenly did not have money to lend out.

As a result, bank lending to both the private and public sector was quickly contracting. The monetary contraction promised a deflationaryrecession .

Now, however, it seems the ECB has decided to start allowing banks to exchange a whole host of assets for euros. There will be some discount to the assets but nothing like what the market would demand.

So, yes, in effect the ECB will overpay for the assets. But in order to fight the contraction, it needs to overpay. If it discounted all the way down to market levels, the entire exercise would be pointless.

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