It’s hard to say from the headlines whether proactive deficit reduction measures are slowing the economies to the point where the slowing is causing their deficits to increase.

However, if that is the case, continuing their deficit reduction efforts will only make things worse, to the point of forcing social upheaval.

And the rising deficits will begin to weaken the euro, as the deficit reduction that initially worked to strengthen the euro reverse.

And higher rates from the ECB will only serve to further increase national government deficits via higher interest payments by those same governments.

This also makes euro ‘easier to get’ and thereby weakens the currency.

Yes, the euro zone is seeing ‘inflation’, as they define it, moving higher, but under current conditions I don’t see any channel from rate hikes to lower ‘inflation’, again as they define it. But I do see how higher rates can instead add to the general price level through income interest and cost channels. All of which would be exacerbated should this policy also cause the euro to depreciate.

With regards to funding, there is nothing operationally to stop the ECB from, for all practical purposes, funding/backstopping the entire banking system as well as the national governments.

The question is the political will, which is not quantifiable.

And the solution remains painfully simple- the ECB can simply announce an annual payment of 10% of the euro zone’s gdp to the national governments on a per capita basis.

This will have no effect on inflation as it won’t get spent. It will only serve to allow all of the national governments to borrow at the ECB’s target rate, which would lower funding costs for the nations currently paying premiums for funding.

This will also give the ECB a lever to control deficits- the threat of suspending a nation’s funding if it is not in compliance.

And by removing the threat of market discipline from funding, the region would be free to set their stability and growth pact deficit targets at levels designed to achieve their macro economic goals for employment, output, and price stability.

Euro-Area Debt Reaches Record 85.1% of GDP as Crisis Festers

(Bloomberg) Euro-area debt reached a record in 2010. Debt rose in all 16 countries that were using the euro last year, lifting the bloc’s average to 85.1 percent of gross domestic product from 79.3 percent in 2009, the European Union’s statistics office said. Greece’s deficit topped expectations and debt ballooned to 142.8 percent of GDP, the highest in the euro’s 12-year history. Ireland’s debt surged the most, by 30.6 percentage points to 96.2 percent of GDP. Contingent liabilities from guaranteeing the banking system after the 2008 financial panic now amount to 6.5 percent of GDP, down from 8.6 percent in 2009, Eurostat said.