Excitement is almost guaranteed this week, with both the Federal Reserve and the European Central Bank pondering their next moves. At the moment, I am more fascinated with the latter, as it represents the more fast moving policy failure for the moment. In response to that disaster to date, it is now widely expected that the ECB will deliver a significant policy expansion, possibly accepting its responsibility of lender of last resort for sovereign debt in the Eurozone. I think it is widely believed that this will be the turning point in Europe. In some ways, yes, as it would keep the threat of imminent dissolution at bay. But the Eurozone will still be fundamentally hobbled by a devotion to re-balancing via austerity-driven internal devaluation. This does not offer a promising long-run outcome.
The sequence of events of last week is becoming clearer. Last Monday, Spanish Economy Minister Luis de Guindos met with his German counterpart. Initial reports indicated no new initiatives were in the works. Subsequent reports suggest otherwise. Friday we learned, via Reuters:
Spain has at last conceded it may need a state bailout and policymakers are considering writing down Greek debt to their central banks, European officials said on Friday, as markets anticipated radical new action to pull the continent out of its debt maelstrom…
…A euro zone official said Economy Minister Luis de Guindos had brought up the prospect of a 300 billion euro bailout this week at a meeting with Germany’s Finance Minister Wolfgang Schaeuble. The official spoke on condition of anonymity because he was not authorized to brief
“De Guindos was talking about 300 billion euros for a full program, but Germany was not comfortable with the idea of a bailout now,” the official said.
He said the question would be put off until the euro zone’s new, permanent bailout fund, the European Stability Mechanism, is up and running. He also said that Germany appeared to be softening its opposition to giving the ESM a banking license, which would allow it to borrow money and deploy more firepower if called upon to rescue an economy as big as Spain’s.
So it sounds like de Guindos went to Schaeble with hat in hand, only to be told that at best Spain would need to wait its turn. Meanwhile, market participants, sensing Spain is teetering on the brink, were pummeling the nation’s stock and bond markets, sending yields soaring, thus ensuring a bailout was necessary (Interesting aside – at what interest rate does Spain not need a bailout, and would that rate become an ECB target? Sounds like a good project for an investment bank research team.) ECB President Mario Draghi, smelling disaster in the wind, breaks down and delivers some now famous remarks in London, including this line:
To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.
This indicates Draghi has finally found away around the mandate prohibiting monetizing sovereign debt, laying out the justification for bond purchases as necessary to implement appropriate monetary policy. This generates a massive global relief rally, as everyone and their brother, expect of course apparently everyone at the ECB, knows that only the ECB has the firepower to stop the repeated cycle of panic endured by Europe. It seems like a real, promising plan is in the works. Via Bloomberg:
Draghi’s proposal involves Europe’s rescue funds buying government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its record low interest rates, the officials said. Further ECB rate cuts and long-term loans to banks are also up for discussion, one of the officials said.
I don’t think Draghi has publicly stated this as a proposal, but instead reporters have pieced this together from contacts within the Eurozone. In any event, to the extent that their exists any substantial opposition to such a plan, that opposition rests with – caution, spoiler alert! – Germany. But you guessed that already, didn’t you? Via Reuters:
Germany’s Finance Minister dismissed reports Spain is about to ask the euro zone bailout fund to purchase its bonds, and talked down fears about its spiralling borrowing costs in an interview with Welt am Sonntag newspaper made available on Saturday.
“Spain’s financing needs in the short-term are not so high. High interest rates are painful and they create a lot of uncertainty, but it is not the end of the world, if you have to pay a few percent more at a few bond auctions,” Wolfgang Schaeuble said.
Asked if there was any truth to speculation that Spain would shortly ask the euro zone rescue fund for help via buying its bonds, Schaeuble answered: “No. There is nothing to these speculations.”
And from the FT:
Germany’s powerful Bundesbank issued a reminder that it still opposed sovereign bond purchases by the European Central Bank, dampening market optimism after ECB president Mario Draghi hinted he could act more decisively in the eurozone debt crisis.
This, I think, is the state of play heading into Monday morning. Basically, Spain is in all-liklihood on the brink of disaster, threatening to drag the rest of the Eurozone with it, Draghi sees this and has made some very, very big promises to deliver imminent action to keep the ship afloat, but he may face internal resistance that necessitates watering down his plans.
Now, at what levels will such a plan work? The short-game here is pretty obvious. It is tough to bet against Spanish or Italian debt if you think the ECB is set to cap borrowing rates. Now think about the long-game. Does it, by itself or in concert with other plans floated in Europe, put the Eurozone economy on firm footing? In my opinion, no. To understand why, one needs to read the full text of Draghi’s market-moving remarks.
I struggled with the remarks, and was happy to see that I was not alone. Paul Krugman describes them as strange. I found them downright incomprehensible.
Draghi begins with the analogy that Europe is like a bumblebee. No one believes it should be able to fly, but it did. Then people stopped asking the question of why it should be able to fly until the financial crisis. Now the job is too restore confidence in the Eurozone so that is become a bee, which everyone believes flies.
No, it is not an easy analogy to decipher. But the bottom line seems to be this: There is not anything fundamentally wrong in the Eurozone that prevents a fully functioning economy, it is only a crisis of confidence.
It’s not me, it’s you.
Draghi then starts the comparisons:
The first message I would like to send, is that the euro is much, much stronger, the euro area is much, much stronger than people acknowledge today. Not only if you look over the last 10 years but also if you look at it now, you see that as far as inflation, employment, productivity, the euro area has done either like or better than US or Japan.
I wish he would quantify these comparisons. Putting that aside, as well as the low bar of Japan and the US in the midst of the most significant economic downturn since the great Depression, Draghi does not seem to realize the importance of capital flows from the core to the periphery. If you don’t understand this, you don’t understand you need a full on reversal of these flows to keep the Eurozone economy flying. See Paul Krugman.
Not understanding internal capital flows. Strike one for Draghi. He continues:
Then the comparison becomes even more dramatic when we come to deficit and debt. The euro area has much lower deficit, much lower debt than these two countries. And also not less important, it has a balanced current account, no deficits, but it also has a degree of social cohesion that you wouldn’t find either in the other two countries.
So many things wrong here, beginning with the obvious morality play: Debt and deficits are bad, and therefore the Eurozone is stronger than the US or Japan. Again, he fails to recognize the importance of the internal divergence in debt and current account deficits is a driving factor in this crisis. Or, more accurately, that the Eurozone economies are too disparate to function under a single monetary policy.
I don’t even know what to say about the social cohesion story. Granted, it has been a decade since closely followed Japan, but, really, Europe has more social cohesion than Japan? The combination of morality play, focusing on the aggregate rather than lack of economic cohesion among the underlying desegregate, and the bizarre appeal to social cohesion is strike two for Draghi.
Draghi anticipates my criticism:
The second point, the second message I would like to send today, is that progress has been extraordinary in the last six months. If you compare today the euro area member states with six months ago, you will see that the world is entirely different today, and for the better.
And this progress has taken different shapes. At national level, because of course, while I was saying, while I was glorifying the merits of the euro, you were thinking “but that’s an average!”, and “in fact countries diverge so much within the euro area, that averages are not representative any longer, when the variance is so big”.
But I would say that over the last six months, this average, well the variances tend to decrease and countries tend to converge much more than they have done in many years – both at national level, in countries like Portugal, Ireland and countries that are not in the programme, like Spain and Italy.
So now you are on pins and needles. What exactly is he talking about? What convergence? Convergence to Ireland’s unemployment rate? The answer:
The progress in undertaking deficit control, structural reforms has been remarkable. And they will have to continue to do so. But the pace has been set and all the signals that we get is that they don’t relent, stop reforming themselves. It’s a complex process because for many years, very little was done – I will come to this in a moment.
No problem with convergence of structual reforms, although I sense he expects a more rapid positive economic response than is reasonable. More important is his focus on deficit convergence. This persistent belief in expansionary austerity will remain the Achilles heal in any European forecast. It guarantees the public sector will continue to deleverage as the private sector deleverages. This is a long-term negative for the Eurozone.
Failure to recognize the the negative weigh of austerity. Strike four. More:
But a lot of progress has been done at supranational level. That’s why I always say that the last summit was a real success. The last summit was a real success because for the first time in many years, all the leaders of the 27 countries of Europe, including UK etc., said that the only way out of this present crisis is to have more Europe, not less Europe.
A Europe that is founded on four building blocks: a fiscal union, a financial union, an economic union and a political union. These blocks, in two words – we can continue discussing this later – mean that much more of what is national sovereignty is going to be exercised at supranational level, that common fiscal rules will bind government actions on the fiscal side.
Then in the banking union or financial markets union, we will have one supervisor for the whole euro area. And to show that there is full determination to move ahead and these are not just empty words, the European Commission will present a proposal for the supervisor in early September. So in a month. And I think I can say that works are quite advanced in this direction.
Failure to understand that “fiscal union” in the European context is an “austerity union,” not the supernational agency with broad tax and transfer powers that represents a real “fiscal union.” Strike five. Failure to understand that the time it takes for Europe to reach a decision is vastly different than the speed at which markets react. Strike six.
Draghi than appeals to the permanence of the Euro:
But the third point I want to make is in a sense more political.
When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro.
And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.
I find this hilarious because it seems to me that the most vocal advocate of the idea that the Eurozone is not permanent is the force behind the Euro, the Germans, who so frequently voice the opinion that Greece is a lost cause. But I don’t think it should be a strike against Draghi; he really sees the project is irreversible, which speaks, in theory, to his willingness to ultimately embrace the role of the ECB as a lender of last resort. With that in mind:
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
The “within our mandate” condition is strike seven. The 2% inflation target is another factor that will be a weight on the European economy. See Paul Krugman. Draghi continues:
There are some short-term challenges, to say the least. The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area. Investors retreated within their national boundaries. The interbank market is not functioning. It is only functioning very little within each country by the way, but it is certainly not functioning across countries.
And I think the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation.
There are at least two dimensions to this. The interbank market is not functioning, because for any bank in the world the current liquidity regulations make – to lend to other banks or borrow from other banks – a money losing proposition. So the first reason is that regulation has to be recalibrated completely.
The second point is in a sense a collective action problem: because national supervisors, looking at the crisis, have asked their banks, the banks under their supervision, to withdraw their activities within national boundaries. And they ring fenced liquidity positions so liquidity can’t flow, even across the same holding group because the financial sector supervisors are saying “no”.
So even though each one of them may be right, collectively they have been wrong. And this situation will have to be overcome of course.
I see the financial fragmentation as a longer-run challenge. Indeed, this is really the factor that is preventing the effective transmission of monetary policy, not the interest rate on Spanish debt. And the history of financial crisis is that you cannot simply flip a switch and normal lending activity will resume. Moreover, ECB actions have almost certainly aggravated the challenges. Tying the banks to sovereign debt via the LTRO funding and then failing to serve as a lender of last resort to eliminate default risk certainly didn’t do the banks any favors. More to the point, the ECB encouraged the financial fragmentation by letting the crisis fester to this point and not recognizing the lack of social and economic cohesion in the Eurozone (see above). If the collective action was wrong, it was because the individual actions were reacting to poor ECB policy.
Failure to understand their role in perpetuating the crisis. Strike nine.
And then there is a risk aversion factor. Risk aversion has to do with counterparty risk. Now to the extent that I think my counterparty is going to default, I am not going to lend to this counterparty. But it can be because it is short of funding. And I think we took care of that with the two big LTROs where we injected half a trillion of net liquidity into the euro area banks. We took care of that.
Then you have the counterparty recess related to the perception that my counterparty can fail because of lack of capital. We can do little about that.
Then there’s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to do, as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty – they come into our mandate. They come within our remit.
I am going to focus on the sovereign debt issue. Draghi breaks it into two parts, default and convertibility. Presumably, convertibility is the risk that Euro-denominated debt will be converted into debt denominated in a revived national currency. He seems to be saying that that can deal with the convertibility risk because it represents the willingess of investors to believe the Euro is not permanent. But is is permanent, he just said so. But I don’t think it is the convertibility issue is at play. I think that investors genuinely fear default, and that such default will be driven by the ECB’s failure to serve as lender of last resort. So that Spanish default is possible even if Spain remains in the ECB. Much like Greek default was possible.
I think the commitment to serving as lender of last resort might be different than commitment to the Euro alone. In other words, what Draghi is thinking of delivering may fall short of what markets are expecting at this point. Which would be consistent with European policy to date, and with the tone of Draghi’s remarks – policymakers always think they are taking big steps, but they are so far behind the curve market participants see baby steps at best.
Draghi needs to deliver big this week. If Draghi overpromised, possible strike ten.
Bottom Line: Yes, I am a Euroskeptic, so feel free to take my comments with a grain of salt. Discount as appropiate. But when I read Draghi’s remarks, I see a policymaker in denial, not wanting to understand the root causes of the crisis. Thus he sees the crisis in terms of simply lack of confidence rather than one with important fundamental factors. Moreover, he is trapped by the austerity framework, not seeing that this is a failing strategy. I don’t think he sees the ECB’s complicity in supporting the crisis. And I think Draghi is representative of the average policymaker in Europe. Which leaves me still convinced that Europe’s future is either Depression or continued recession/stagnation. The ECB can prevent the former, but lacking a complete overhaul of the implications of protracted fiscal austerity and a “fiscal union” the cements such austerity in place, coupled with a serverely damaged financial system, I am challenged to see how the latter can be overcome.
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