This week’s newsletter will focus on Europe again as this morning the European summit has produced significant changes in European economic policy. Spanish Prime Minister Rajoy and Italian Prime Minister Monti threatened to ‘block everything’ including France’s vaunted 120 billion euro growth package unless the Germans relented on the EuroTARP issue. Germany has relented and that has caused a huge relief rally in Italian and Spanish sovereign debt, which have rallied in excess of 30 basis points.
While I still believe that events on the ground (including bank runs) are moving too quickly for European leaders to change policy enough to prevent the European economy worsening, this deal is a signal that there is still some hope that Europe can prevent bank runs and debt deflation.
What Europe proposes
Here’s what’s now on the table:
- EuroTARP. The Europeans put the decoupling of bank distress and sovereign risk at the center of their post-meeting Memorandum of Understanding. Along those lines Rajoy and Monti were able to get Merkel to agree to have the EU bailout funds EFSF and ESM inject money directly into banks without seniority. This is a significant concession because, as you recall, when this deal was announced the market turned away in revulsion as the Spanish sovereign was on the hook. That created a Spanish sovereign death spiral. Significantly, Ireland will benefit from this sovereign debt relief as well and that could mean they avoid a second bailout.
- Growth Pact. The new French President Francois Hollande has championed a growth pact for Europe that would allow Europe to boost aggregate demand by 120 billion euros through infrastructure projects funnelled through the European Investment Bank. This project has been on the table for some time and was expected to occur. However, it is not a huge boost given the debt deflationary dynamics of the current austerity path.
- Austerity Lite. I am hearing conflicting reports about oversight for the bank bailout funds. Italian PM Monti is saying that the troika will not oversee EFSF/ESM bank bailout funds. Meanwhile Merkel and Hollande are saying the opposite. No matter, it is clear that there are no deficit targets attached to this bailout. European leaders are specifically saying that countries which are already taking tough austerity measures could apply for these bank bailout funds without the stringent conditions that were attached to previous bailouts. I have been saying for a while now that Spain and Italy would get a free pass here because they are too big to fail.
- Banking union. The EuroTARP was possible because the ECB will now move into a banking oversight role in Europe with plans for more European-wide banking regulation coming. In my post on the ECB’s Bagehot Rule Policy, I highlighted the fact that "the Council, acting by means of regulations in accordance with a special legislative procedure, may unanimously, and after consulting the European Parliament and the European Central Bank, confer specific tasks upon the European Central Bank concerning policies relating to the prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings." This clause has now been activated and the ECB will take over euro zone bank oversight while the institutional arrangements for a euro zone-wide banking union are worked out.
Overall, this summit represents a significant move because of the reversal on the bank bailout. Last Friday I talked about Europe moving from smaller bailouts plus austerity to bigger bailouts plus austerity lite, predicting that we would see the second and third points of the bailout package. What is a surprise is the bank – sovereign decoupling element that Monti and Rajoy were able to get through. In the absence of that, the EU summit would have been a dismal failure. I wrote last week:
Germany, Spain, Italy and France have met to hammer out a unified front ahead of the upcoming European summit and Spanish bailout. This is likely a fleshed out version of the G-20 plan that Barack Obama was privy to. Their answer is the 120 billion euro stimulus package that Francois Hollande has been pushing plus a likely relaxation in targets, what I am calling austerity lite. Meanwhile the ECB has decided to kick the ratings agencies out of the equation by deciding internally what kind of collateral it will accept. The combination of these moves plus the Fed’s operation twist and more QE likely at the Bank of England are hallmarks of a coordinated push to stop the building deceleration in global growth.
Will it work though? I say no. The ECB plan is a surprise and has some of the hallmarks of my ECB Bagehot Rule Policy. It may help to bring interest rates down as the LTRO did in November. But, again, credible liquidity targets rates not quantity. So, when the next problem arises, this policy will run into trouble and they will need to increase purchases. The bailout/austerity lite solution for Spain is what I told you to expect in late April. But, of course, this bailout falls even short of the one I believed was coming in that the Spanish bailout is not a EuroTARP at all. IMF head Christine Lagarde is quoted below as imploring Europe to make it a EuroTARP. But I doubt they will listen.
So my view is that this is more of the same, another extend and pretend type of shock and awe. It’s incrementalism designed to move inexorably toward the kind of fiscal union that Germany want but that commentators like Tim Duy say won’t work. I hate to be negative here but I’m not impressed.
I am more impressed now but there is still a lot of work to be done.
The problems
One big problem with Europe’s solution is the lack of firepower at the EFSF/ESM. These funds are clearly not big enough to deal with either Spain or Italy. And it should make sense because Spain and Italy are the third and fourth largest economies in Europe. Germany and France could not possibly bail them out. That means Europe’s solutions have to get Spanish and Italian bank yields down without relying on these funds.
Policy makers took the first step in getting yields down by agreeing to inject funds directly into Spanish and Irish banks instead of crippling the sovereign with that responsibility. However, the ESM is now running into ratification problems in Germany and may be deemed unconstitutional. This would be a significant blow were it to occur.
In Ireland, the bank debt problem is largely behind us. Property markets could fall further but almost all of the bad debt seems to be recognized. Taking this debt off of the government’s books and ‘socialising’ the losses across Europe is the right way to deal with the problem. And that could mean that Ireland can return to the markets to access funding in the near future. Let’s remember that German banks, especially Germany’s state banks, the Landesbanken, are severely undercapitalised and so these funds will not just be for Ireland or Spain but could be used by Germany, Austria, Belgium or France, all of whom have problem banks on their hands.
While Ireland is looking better, the problems at Spanish banks are mounting because Spain has taken so long to recognise bank losses. As I said in yesterday’s daily on the synchronised global slowdown:
Deficits are already 3.41% when the full year target is 3.5% and GDP is now declining at an accelerating rate. Add the increased sovereign yields, the falling house prices, the bank bailouts and the high rates of unemployment and it is clear that Spain is hitting a Greek-like debt deflation right now. I expect the situation to get considerably worse, putting sizable holes in bank balance sheets. The likelihood of a sovereign bailout and a second bank bailout is a lock under present circumstances.
So, ultimately you are going to need the ECB involved. Either the ECB will have to monetise Spanish and Italian debt by buying it in by continuing its SMP or via another LTRO program or they will need to implement an ECB Bagehot Rule Policy as I have proposed they do. I have become increasingly pained at how slow Europe’s policy makers have been in making necessary policy commitments. So I expect more of the same foot dragging here and therefore we won’t see a Bagehot Rule Policy. I hope I am wrong. But my sense is we will need to see more crisis before that could occur.
The bank runs, debt deflation and Europe’s capital account imbalances
My biggest fear here is that Europe continues to dither while the bank runs occur. We first saw talk of people pulling deposits out of the periphery in the context of Ireland in November of 2010. My argument for Ireland then is the same as it is now. I explained how the Irish can prevent a bank crisis from becoming sovereign default in exactly the way we are now seeing Europe move forward, by allowing the sovereign to repudiate its liability for the bank debts. These are private debts and the shareholders and subordinated debtholders must take the hits first. To the degree, bailouts are conducted, it makes no sense for them to come from a national level since the euro zone member states are debt-constrained currency users that can be bankrupted. These funds must come from an EU-wide level and that means EU-wide banking oversight, exactly what we are now seeing. So I am hopeful on this front.
Where I still see problems is in the eurozone exit talk. If you recall, as the Italian crisis was heating up, the junior members of Germany’s governing coalition were saying Europe should throw the Greeks out of the eurozone. Reports then were even that Germany was preparing for Greece’s exit. Eventually even Angela Merkel and her finance minister broke the taboo and started discussing a Greek exit. Yes, I see Greece’s eventual exit as likely because Greece cannot eradicate its persistent current account deficits at the prevailing exchange rate. But the talk of Greece’s exit creates a big problem in terms of contagion. And it has created a wholesale flight of capital out of the eiurozone periphery, as indicated by Target2 balances.
Marshall Auerback has been very good in breaking down why using the arguments of Peter Garber, who foresaw this before the euro came into existence. Here’s what Marshall writes:
As Yanis Varoufakis has noted “the lack of a constitutional (or Treaty-enabled) process for exiting the Eurozone has a solid logic behind it. The whole point of creating the common currency was to impress the markets that it is a permanent union that will guarantee huge losses to anyone bold enough to bet against its solidity.”
As Varoufakis argues, a single exit suffices to punch a hole through this perceived solidity. It goes back to the fundamental flaw cited by Peter Garber at the time of the euro’s inception. As long as there was no perceived probability of euro exit by any euro nation, the established transfer system coupling private markets with European system of Central Bank support (Target 2, ELA, ECB repos) would function like any other monetary system in a single nation state. However, Garber recognized that if there arose the prospect of a euro exit and, therefore, a devaluation risk for holders of deposits in the banks domiciled in the country slated for exit (e.g. Greece or Spain), the European monetary system would be exposed to a bank run. Under the EU treaty capital mobility was guaranteed. Under the common currency deposit transfers from domestically domiciled banks in countries at risk of euro exit (e.g. Greece, Spain) to banks domiciled in other euro nation states (e.g. Germany, Netherlands) was costless. Faced with any non-negligible perceived risk of a euro exit and thereby a devaluation loss, rational market participants should move all their deposit funds from the banks domiciled in the country at risk of euro exit to banks domiciled in nations at the Eurozone’s unassailable core.
In the United States we have 50 states and one central bank. Likewise in other Federal systems such as Canada and Australia. In all cases, there are fund transfers across states. And these are permanent institutional arrangements. It is highly likely that West Virginia or Mississippi will remain long term recipients of Federal transfer payments, even if they remain “uncompetitive” vis a vis, say, Texas or California.
But there cannot be any prospect of a secession of a state that will bring with it its own devalued currency. Hence, there is no incentive for deposit flights from banks in one state or region to another. Therefore, private markets, with a little help from the Fed, will close the financial circuit to the extent there are such fund transfers. The European Monetary System was supposed to work that way. And as long as no one worried about any country leaving the euro, it did. But once the risk of euro exit on Europe’s periphery raised its ugly head, the euro system became completely different. Peter Garber argued that, given such a perceived prospect, the euro system was a perfect mechanism for a deposit run. And once doubts arose in 2009 about a possible euro exit by Greece and Ireland, a deposit run began – and in earnest.
So, the problem here is that the euro system is designed to function like the US in terms of its banking system without any capital controls. This situation pre-supposes currency area integrity. Once any hint that the area’s integrity will be compromised occurs, you get bank runs out of the banks within areas in the currency system that would likely exit. Randy Wray puts it very starkly: "anyone who still has a Euro deposit in any bank other than a German bank is either a philanthropist or a fool."
Now, Randy is a eurosceptic, so I see his statement as hyperbole but the point is valid; questions about euro zone integrity lead to bank runs and exacerbate the banking problems in the periphery, creating debt deflation as credit contracts. Just to be clear, what has happened in Greece is that the talk of Greece’s exit from the eurozone caused capital flight out of Greek banks, weakening their deposit base and ability to fund themselves. This in turn caused Greek banks to become dependent on the ECB and the Greek central bank’s ELA for funding. The lack of deposits also caused a sharp contraction in credit availability in Greece, adding a credit decelerator to the austerity-induced economic contraction already ongoing. This is debt deflation.
Spain has now succumbed to debt deflation as well. And following the Greek lines, you would see credit contraction adding a decelerator to Spanish economic woes. The problem in Spain is that property prices are still dropping, meaning that asset values on Spanish banks’ balance sheets are falling, adding a further acceleration to the debt deflation. If Europe doesn’t get out in front of this, we could see a wholesale banking system collapse in Spain. So, again, my worry is the bank runs. Europe is already in recession but the policy response to date has meant that credit automatically contracts in the periphery, making the situation that much worse.
I should also note that this is ironically the exact opposite situation to what we witnessed during the housing bubble. During the housing bubble, German capital fled the weak investing environment of a Germany weakened by a post-re-unification property bubble. This helped inflate bubbles in Spain and Ireland (as Swedish and Danish bank capital helped inflate bubbles in the Baltics). Now that the euro zone breakup talk has advanced, the capital is going the other way and all indications are that a housing boom is building in Germany, Finland and Austria in part due to the influx of capital from the periphery. All of this is disastrous for Europe’s economic performance.
Target2 problems
One last piece of the puzzle I should fit in here concerns the Target2 problem. In the euro zone, national banking systems clear their balances via an inter-central bank clearing system called Target2, which is short for Trans-European Automated Real-time Gross Settlement Express Transfer. Target 2 claims at the national central bank level arise from trade, current account and financial transactions between national banking systems. It’s what allows an Italian to purchase a German car in euros in a seamless, easy way. This is the operational heart of the euro system.
There has been a lot of talk about Target2 recently, however. High-profiled Germans like Hans-Werner Sinn and Jens Weidmann are on the warpath about the enormous Target2 imbalances which now reflect not just current account imbalances but also capital flight out of the periphery to Germany. They argue that if the euro were to break up, Germany could lose up to 20 percent of GDP from vaporised Target2 claims. Economist Karl Whelan of University College Dublin has made good counterarguments that this is wrong-headed. Also see Ambrose Evans-Pritchard’s comments on this. But the issue remains a focus of the euro collapse story and people like Sinn have argued that Germany should disrupt the target2 system to prevent further liabilities from building.
Sinn’s populist commentary on this issue is cynical and reckless. They exacerbate the problem and make a poor outcome more likely. In any event, a commenter from Italy made an interesting point in reference to a post by Randy Wray on this and why he is keeping his deposits in Italy:
My life savings still reside in several Italian banks, partly due to a sliver of optimism but mainly because I fear that if / when the sh*t really hits the fan, and a large share of Greeks, Italians and Spaniards have already transferred their savings to German banks, that Germany will pass a law expropriating funds received from the periphery in order to help pay for the unfathomable costs of the end of the Euro.
Now wouldn’t that be even more foolish that keeping everything in Italy?
Bottom line: the situation regarding a euro breakup has created capital flight and massive uncertainty that can only depress European economies that much more. The Target2 arguments are very central to this theme.
Conclusions
After the Italian crisis, I thought we were there, that European policy makers were going to put something lasting together. However, recently I wrote you saying that I am moving to disorderly breakup as base case for the euro zone. Much of this has to do with the Spanish bank bailout, the bank runs, and the Target2 talk. At the end of that post, I wrote:
What we need to see is some sign that European policy makers get it, that they understand that the bank runs have begun. If they don’t act soon, it will be too late and we will be back in 1931 again.
In my view, this deal qualifies as that sign. It’s not an end all and be all because it still has a lot of problems but it is a step in the right direction.
I wrote on Wednesday:
So what I expect to happen in Europe is that we will go from bailouts and austerity to bigger bailouts and austerity lite, buying some more sovereign bonds and pushing back fiscal targets but not changing the basic approach.
And this deal changes none of that. Europe is still on an incrementalism path that means that events on the ground will get worse, forcing leaders again and again to shift policy to meet the realities of the situation. Will they be able to meet that challenge? I have serious doubts.