The end of European bailouts and the beginning of monetisation
In the German press, there have been a number of stories recently that indicate that the German government will not commit any more money to bailouts in the euro zone. Specifically, the reports of greatest interest have to do with Germany’s neither funding a new Greece or topping up the EFSF/ESM bailout facilities. I think these reports are credible and I am writing this note as to what I believe they mean for European economic and monetary policy.
First, the Greek reports come via statements made by Michael Fuchs, CDU deputy Bundestag head and a senior member of German Chancellor Angela Merkel’s party. Fuchs warned earlier today that Germany would veto further aid to Greece if the country has not met the conditions of its previous bailouts. Fucks told German business daily Handelsblatt that "even if the glass is half full, that won’t be sufficient for a new aid package. Germany cannot and will not agree to that." Fuchs also voiced resistance to allowing the ESM permanent European bailout fund to receive a banking license in order to facilitate ECB monetisation of periphery debt.
Second, all along Germany has indicated that it is resistant to increasing funding of the ESM and EFSF bailout facilities. This presents a problem in the case of Spain and Italy because of the size of those economies. The reason for the talk of a European banking license for the ESM is a recognition that these funds would be soon exhausted if they were to have to buy Spanish and Italian debt to maintain yields at reasonable rates for those governments. Willem Buiter, Chief Economist at Citigroup, has been most vocal in predicting that these facilities will be inadequate when Spain and Italy hit the wall and that more extreme measures will have to be taken.
The basic dilemma here is that almost all of the eurozone governments including Germany carry high debt burdens in excess of the Maastricht Treaty. For example, Germany has been in breach of Maastricht Treaty in 8 of 10 years since 2002, has been over the Maastricht 60% hurdle in each of those ten years, and now carries a debt to GDP burden above 80%. The ratings agencies are onto this and Moody’s has recently downgraded all of the remaining AAA credits in the euro zone except Finland (whose fiscal health is buoyed artificially by a property bubble, I might add). If you look at the contributions to the ESM then, you can see that it cannot be a AAA-rated facility.
Note that of the countries committing to the ESM, Spain, Ireland, Portugal, Greece and Cyprus have already requested a bailout and Slovenia may do as well. That represents a full 19.4% of the bailout funds, leaving Germany, France and Italy as the major providers of bailout money. Germany is the largest contributor but Germany cannot save the euro alone because it simply doesn’t have the fiscal resources to do so. Italy itself is in great jeopardy. And France has received warnings or downgrades from ratings agencies about its own fiscal health. The only country measured as AAA is Finland and it contributes only 1.8% of the bailout money.
The bottom line here is that the ESM is both underfunded and backed by weak fiscal agents. It cannot possibly withstand a crisis in Italy or Spain.
As I argued last year, "questioning Italy’s solvency leads inevitably to monetisation":
Italy owes German banks 116 Billion euros. If Italy were to default, the result would be financial Armageddon and a major worldwide Depression, perhaps one worse than the Great Depression. The Germans know this. And as I outlined above, the route to a sustainable solvency path that leads to liquidity for Italy is blocked at every path. Italy will continue to pay a huge premium for its debt. The only way to ensure Italy’s medium-term solvency is to have it borrow in a currency whose creator is credibly committed to creating an unlimited supply of money in order to backstop Italy’s debt if necessary.
At present, the ECB is buying just enough bonds to send a message to Spain and Italy that they need to live up to their austerity quid pro quo or else the ECB will stop buying. The ECB wants to prevent ‘free riders’ from making the euro a weak currency. But, let’s be clear, a currency with “no lender of the last resort” was a ridiculous concept from the start. The crisis we are witnessing now was always going to happen. As much as the ECB resists it now, they have limited choices: monetise or face a global economic collapse. The longer they wait, the worse it will get.
I should point out that when I talk of a currency with “no lender of the last resort”, I am using the language of those who say that the central bank acts as a lender of last resort to sovereigns. The reality, however, is that the central bank is the lender of last resort to private banks and these banks lend to sovereigns – a semantic but sometimes meaningful difference.
In my view, ECB head Mario Draghi is finally trying to get out in front of this by making statements as to what the ECB is prepared to do. While market watchers were disappointed that he did not follow through on his statements about the ECB’s willingness to do "whatever it takes" at the last ECB press conference, he did lay out a platform for action. The central plank of the Draghi Plan is to have the rescue fund buy bonds on primary and the ECB on secondary market. This would obviate the need for an ESM banking license then.
Nonetheless, my view is that Draghi’s comments about the ECB doing “whatever it takes” are irrelevant.
The ECB’s willingness to work in concert with a bailout fund of limited financial resources like the EFSF or the ESM to buy peripheral debt changes none of that. Unless the ECB is willing to buy unlimited amounts of debt at specific yields or spreads, solvency will always be an issue.
So, the other statements that Draghi made during the press conference are much more relevant in understanding what the ECB could do. He talked of "unlimited open-market operations" due to "convertibility risk". Ambrose Evans-Pritchard sees this as a way to have "elegantly finessed" the no-bailout clause in the Maastricht Treaty. Evans-Pritchard says that "[m]arkets may dislike the complexities of this. They should not misjudge the radical shift in policy that has occurred." I agree.
As I noted when suggesting the ECB’s Bagehot Rule Policy earlier this year, the Lisbon Treaty specifically tasks the European System of central Banks with a mandate "to promote the smooth operation of payment systems." I argued then and am arguing here as well that:
The question, therefore is how much discretion should the ESCB be allowed "to promote the smooth operation of payment systems" without compromising ECB or ESCB independence.
In sum, the euro zone is now in an existential crisis because of the potential insolvency of Spain and Italy, the bank run out of the periphery caused by convertibility risk and the negative economic effects of crushing fiscal austerity. The euro will break apart unless its leaders can find a way of eliminating all three of these problems: sovereign insolvency, bank runs and economic depression.
As I have long held, there are three options for the euro zone: monetisation, default, or break-up. At the beginning of this year, I predicted that the euro crisis would escalate in Spain and Italy. It has done. But there’s more to it than that. The question is what then? Here’s exactly what I said in January:
The ECB becomes more explicit about its backstops: As I write this, Italian interest rates are now edging over 7%. The question, especially when the Italians have to roll over so much debt, is how do they continue on in that environment? The answer is they can’t. If Italian yields stay at 7% for too long, everyone not just some bond investors will start to believe they are essentially bankrupt. That gets you into Greece territory. Bottom line: the ECB will then face a stark choice. Make their Italian backstop more explicit or go through a debt deflationary and depressionary crisis and cease to exist as an institution as the euro unwinds. I think they will choose inflation.
First, Spain is the problem child at the moment. But Spain and Italy are joined at the hip. If Spain’s yields go up, so do Italy’s and vice versa. Second, I am less sanguine about the choices now. The ECB will choose inflation, yes. Mario Draghi has already indicated as much. But will he get away with it? I am not so sure there. The economic toll has been terrific and the battle lines are hardening. Germany faces a general election. Italy faces a general election. The German constitutional court is threatening to intercede. Frankly, anything could happen.
My baseline, however, is for a disorderly breakup. Greece will exit the euro zone and this will be a disorderly event. In my view, this could actually make it more likely that we will see monetisation because, like the Lehman crisis, the panic will make people look to stem the tide of debt deflation by any means necessary. So I still believe the ECB will eventually go in guns blazing but it may not happen until Greece leaves the euro. In the meantime, expect policy paralysis in Europe.