John Hussman of Hussman Funds doesn’t think much of the latest bailout program for wayward European countries as should be clear in his commentary this week.

ECB President Jean-Claude Trichet has been quick to deny concerns that the move by the ECB will be inflationary, emphasizing that the intervention will be “sterilized” in order to prevent a major increase in the amount of euros outstanding. This is “totally different,” he argued last week, from the massive increase in monetary base that has occurred as the U.S. Federal Reserve has bought up over $1.25 trillion in debt obligations of Fannie Mae and Freddie Mac. A “sterilized intervention” is one where the euros created through the purchase of distressed Euro-area debt will also be absorbed by selling other assets from the ECB’s balance sheet, in order to take those euros back in.

In order to evaluate the arguments being made, it’s helpful to understand the balance sheet of a typical central bank. Whether in the U.S., Europe, or elsewhere, the basic structure is the same. On the asset side, the central bank has government debt that it has purchased over time. A small proportion of total assets might be held in “hard” assets such as gold, but primarily, the assets of each central bank has traditionally represented government debt – mostly of its own nation (or in the case of the ECB, euro-area governments). As a central bank purchases these securities, it creates an equal amount of liabilities, in the form of “monetary base” (currency and bank reserves).
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In this context, consider the ECB’s proposed 750 billion euro line of defense. Essentially the ECB is saying “We stand ready to buy as much as 750 billion euros of distressed Euro-area debt in order to defend the euro.” Simultaneously, despite the fact that Euro area countries are running large fiscal deficits, the worst being in Greece, Portugal and Spain, the ECB is saying “However, we intend to sterilize this intervention, which will ultimately require that we sell Euro-area debt into the market in order to absorb the euros we create.” The only way that both statements can be true is for the ECB to admit “Therefore, we are fundamentally promising to debase the quality of our balance sheet, by exchanging higher quality Euro-area debt with lower-quality debt of countries that are ultimately likely to default.”.

The worldwide effort to transfer bad debt from the private sector to the public sector and then from the public sector to the central bank really seems to be going well so far…