Daily Archives: December 5, 2011


By Marshall Auerback

Another week to go before the euro blows up, orso we’re told again for the thousandth time. More likely is that the ECB doesbarely enough to keep the show on the road, fiscal austerity continues andriots intensify on the streets of Madrid, Athens, Rome and Paris.  Like the film, “there will be blood” beforethere is any likely change toward a sensible growth oriented policy in the eurozone.

Given the travails of the euro zone, why has theeuro remained relatively robust?  Surely,a currency that is supposedly within weeks of vanishing should be tradingcloser to parity with the dollar?  Yet onecontinues to be struck by the divergence of opinion and actual marketaction.  For all the talk about the europossibly vaporizing by Christmas, it is striking that it remains stubbornlystable at around $1.34 to the dollar, substantially above the low of $1.20,which was reached in May 2010 (when predictions of parity with the dollar wererampant).

By the same token, we have a paradox on theother side as well:  every time itappears as if a solution to the problems posed by the euro look to be close toresolution, the euro strengthens. Perhaps this isn’t so odd, except that thesolution that virtually everybody agrees will work – namely, a sustained andmore holistic bond-buying operation taken up by the European Central Bank (ECB)– is said to represent a form of “quantitative easing” and aren’t we alwaystold that “QE” represents “printing money”, which should cause a currency to godown?  Isn’t that what all of theopponents of the Fed’s program last year were asserting?

Of course, in the case of the European MonetaryUnion, ECB President Mario Draghi insists that such bond buying will not takeplace in the absence of proper “sequencing”, by which he means agreed fiscalausterity first, bond buying afterward. The effect of the former will negate any potential impact of the latter,since the “inflation channel” (to the extent that inflation occurs at all) canonly come through fiscal policy.  Andcertainly, in the teeth of a severe recession, such cuts as those proposed bythe client state governments of Italy and Greece (along with a renewed assaultby President Sarkozy on the French welfare state) will almost certainlyexacerbate the profoundly deflationary pressures now operating in theeurozone.  Ultimately, this will surely have theresult of creating substantially more social instability and bloodshed, but itmight have little impact on the euro itself.

So what is actuallyhappening to the euro? Let’s take a step back from the panic talk. The mostrecent data from the COMEX suggests that speculators are heavily short euro andyet the currency has fallen less than 10% from its recent highs.   The question one might legitimately poseis:  at what point does the currentfiscal austerity produce higher deficits, which in theory should produce aweaker euro (as the euros become “easier to get”)?

I have been wrestling with this issue, and keepgetting back to a strong currency, even with increased fiscal deficits. Why? 

For one, the ECB’s bondpurchases in the secondary market are operationally sustainable andnon-inflationary.  When the ECBundertakes its bond buying operation, its debt purchases merely shift netfinancial assets held by the ‘economy’ from national government liabilities toECB liabilities in the form of clearing balances at the ECB. At thesame time, so-called PIIGS government liabilities shift from ‘the economy’ tothe ECB.  Note: this process does not alter any ‘flows’or ‘net stocks of euros’ in the real economy.

As Warren Mosler and I have argued before, so as long as the ECB imposes austerian terms and conditions,their bond buying will not be inflationary. Inflation from this channel comesfrom spending.  However, in this case the ECB support comes only withreduced spending via its imposition of fiscal austerity.  Mr. Draghi has now made this explicit and itis almost certainly the German quid pro quo for tacitly supporting a proposedexpansion of the Secondary Market Program (SMP).  And reduced spendingmeans reduced aggregate demand, which therefore means reduced inflation and astronger currency.   We also knowfrom an authority no less than the BIS (ironically, the same initials as “bloodin streets”) that banks cannot lend out reserves (see here – ), so increasing reserves in the banking system is NOTinflationary per se, as the Weimar hyperinflation hyperventilators continue towarn us. 

Now consider the trade channel: despite today’srapidly weakening economy (Europe is almost certainly in recession today), we are not seeing much deterioration in theeuro zone’s current account deficit. The Eurozone, in fact, seems to be apretty self-contained, and somewhat mercantilist economy, which displays far lessproclivity to import when the economy slides. So even though imports go down,so too do trade deficits, due to falling demand. Exports don’t fall and may infact go up in this kind of environment.

So that’s euro friendly.

As far as what happens if the ECB were to expandsignificantly its bond buying program in the secondary market, the notion thatthe euro would fall is akin to the reasoning that the dollar would collapse if itengaged in QE2. And if what is called quantitative easing was inflationary,Japan would be hyperinflating by now, with the US not far behind.

There is NO sign that the ECB’s buying of eurodenominated government bonds has resulted in any kind of monetary inflation, asnothing but deflationary pressures continue to mount in that ongoing debtimplosion. The reason there is no inflation from the ECB bond buying is becauseall it does is shift investor holdings from national govt. debt to ECBbalances, which changes nothing in the real economy.

But the question which persistently arises whenone advocates a larger institutional role for the ECB is  whether the ECB’s balance sheet would beimpaired, and the MMT contention has long been NO, because if the ECB boughtthe bonds then, by definition, the “profligates” do not default. In fact, asthe monopoly provider of the euro, the ECB could easily set the rate at whichit buys the bonds (say, 4% for Italy) and eventually it would replenish itscapital via the profits it would receive from buying the distressed debt (notthat the ECB requires capital in an operational sense; as usual with the eurozone, this is a political issue). At some point, Professor Paul de Grauwe isright:  convinced that the ECBwas serious about resolving the solvency issue, the markets would begin to buythe bonds again and effectively do the ECB’s heavy lifting for them. The bondswould not be trading at these distressed levels if not for the solvency issue,which the ECB can easily address if it chooses to do so.  But this is a question of political will, notoperational “sustainability”.

So the grand irony of the day remains this:while there is nothing the ECB can do to cause monetary inflation, even if itwanted to, the ECB, fearing inflation, holds back on the bond buying that wouldeliminate the national govt. solvency risk but not halt the deflationarymonetary forces currently in place.

Okay, so who takes the losses?  Well, presuming the bonds don’t mature atpar, no question that a private bank which sells a bond at today’s distressedlevels might well take a loss and if the losses are big enough, then banks inthis position might well need a recapitalization program.. And in this scenarioGermany too could take a hit, as does every other national government as theyuse national fiscal resources to recapitalize. And the hit will get bigger thelonger the Germans continue to push this crisis to the brink.

But that is a separate issue from the questionof whether the bond buying program per se will pose a threat to the ECB’sbalance sheet. It will not:  a big incometransfer from the private bond holders who sell to the ECB, which can build up its capital base via the profits it makes onpurchasing these distressed bonds.  So again, the notion of an ECB being capitalconstrained is insane.

By contrast, the status quo is a loser foreverybody, including Germany.  A broaderECB role as lender of last resort of the kind the Germans are still publiclyresisting, along with their unhelpful talk of haircuts and greater privatesector losses, actually do MUCH MORE to wreck Germany’s credit position thanthe policy measures which virtually everybody else in Europe is recommending.  Why would any private bondholder with amodicum of fiduciary responsibility buy a European bond, knowing that the rulesof the game have changed and that the private buyer could find himself/herselfwith losses being unilaterally imposed? The good news is that there finally appears to be some recognition of thedangers of this approach.  Per the WallStreet Journal:

“Ms.Merkel signalled on Friday that she is having second thoughts about the wisdomof emphasizing bondholder losses: ‘We have a draft for the ESM, which must bechanged in the light of developments’ in financial markets since theGreek-restructuring decision in July, she said after meeting Austria’schancellor in Berlin.

Austrian Finance Minister Maria Fekter, speaking at a conference in Hamburg onFriday, was more direct. ‘Trust ingovernment treasuries was so thoroughly destroyed by involving private sectorinvestors in the debt relief that you have to wonder why anyone still buysgovernment bonds at all,’ Ms. Fekter said.”

There are other issues which aremaking Germany’s position increasingly untenable, notably on the politicalfront, in particular the mounting strains between France and Germany.  Wolf Richter notes that virtually every leading candidatein the French Presidential campaign envisages a much more aggressive role forthe ECB going forward.  If ChancellorMerkel thinks she’s going to have a tough time now, wait until she ispotentially dealing with Francois Hollande, the French Socialist Presidentialcandidate, who is now ahead in the all of the polls, and who advocates a five-point plan which is anathema to Germany’sgoverning coalition:

  1. Expand to the greatest extent possible the European bailout fund (EFSF)
  2. Issue Eurobonds and spread national liabilities across all Eurozone countries
  3. Get the ECB to play an “active role,” i.e. buy Eurozone sovereign debt.
  4. Institute a financial transaction tax
  5. Launch growth initiatives instead of austerity measures.

As Richter notes, issues 1, 2, 3, and 5 are allnon-starters amongst Berlin’s policy making elites.  Even more extreme are the views of Socialistcandidate, Arnaud Montebourg, who has openly spoken of “the annexation of the French rightby the Prussian right.”

On the right, things are not much better.  French President Nicolas Sarkozy risks beingoutflanked by National Front leader, Marine Le Pen (whose father is Jean Marie Le Pen), who is adopting anexplicitly anti-euro candidacy, which isgaining traction as France’s new austerity measures continue to bite intoeconomic growth.   In his futile attemptsto maintain France’s AAA credit rating via increased fiscal austerity, Sarkorisks being hoisted by his own petard, as the likely impact of such measureswill be to take French unemployment back into double digits.  Paying obeisance to the shrine of Moody’s,Fitch and S&P via fiscal austerity is the economic equivalent of seeking tonegotiate a peace treaty with Al Qaeda.

True, Germany might well decide that enough isenough, that the ECB’s actions represent “printing money” and may thereforeinitiate a process of leaving the euro zone. But let us be clear about the consequences:  Were it to adopt this approach, Germany wouldlikely suffer from a huge trade shock, particularly as its aversion to”fiscal profligacy” would doom it to much higher levels ofunemployment (unless the government all of a sudden experienced a Damasceneconversion to Keynesianism – about as likely as a Klansman attending a Presidentialrally for Barack Obama) or reverting to its former policy of dollar buying. Itmight also affect the living standards of the average German as well becauseGermany’s large manufacturers originally bought into the currency union becausethey felt it would prevent the likes of chronic currency devaluers, such as theItalians, to use this expedient to achieve a higher share of world trade atGermany’s expense. Were they confronted with the loss of market share, Germanmultinationals might simply move manufacturing facilities to the new, low costregions of Europe to preserve market share and cost advantage or, at the veryleast, use the threat of moving to extort cuts in wages and benefits to Germanworks as a quid pro quo for remaining at home. Perhaps there would be blood in the streets of Berlin at that point aswell.

In fact, it is doublyironic that Germany chastises its neighbors for their “profligacy” but relieson their “living beyond their means” to produce a trade surplus that allows itsgovernment to run smaller budget deficits. Germany is, in fact, structurallyreliant on dis-saving abroad to grow at all. Current account deficits in otherparts of the euro zone are required for German growth. It is the height ofhypocrisy for Germans to berate the southern states for over-spending when thatspending is the only thing that has allowed Germany’s economy to grow. It isalso mindless for Germans to be advocating harsh austerity for the south statesand hacking into their spending potential and not to think that it won’treverberate back onto Germany.

Now, of course, GermanChancellor Angela Merkel may not consciously know all of these things.  In fact, she termed accusations of Germanyseeking to dominate Europe “bizarre”.  But it is clear to any objective observer that the political quid pro quo for greater ECB involvement indealing with Europe’s national solvency crisis is German control over theoverall fiscal conduct of countries like Greece, Italy, etc. Mario Draghi is Italian, but as Michael Hirsh of the National Journal noted in a recent tweet, the ECB head isplaying a German game of chicken: he is embracing exactly the strategy thatAngela Merkel’s political director, Klaus Schuler, laid out several weeks ago:holding out for fiscal union commitments from the weaker “Club Med”countries, in return for turning the ECB into a lender of last resort.  So whilst many Germans might think they want a smaller, more cohesiveeuro zone without the troublesome profligates, the policy elites in factrecognize that a “United States of Germany” under the guise of aUnited States of Europe, actually suits their aspirations to dominate Europepolitically and economically.  Which iswhy the outlines of a deal along the lines of increased ECB involved as a quidpro quo for greater German control of fiscal policy across the euro zone, isemerging.   It’s the equivalent of thegolden rule:  “He who has the gold,rules.” 
 It is high stakes poker, and one which willultimately lead to far more bloodshed, as my friend, Warren Mosler, aptly notedin a recent blog post:

Thereis no plan B. Just keep raising taxes and cutting spending even as
those actions work to cause deficits to go higher rather than lower.
Sowhile the solvency and funding issue is likely to be resolved, the relief rallywon’t last long as the funding will continue to be conditional to ongoingausterity and negative growth.
Andthe austerity looks likely to not only continue but also to intensify,
even as the euro zone has already slipped into recession.
So from what I can see,  there’s no chance that the ECB would fundand at the same time mandate the higherdeficits needed for a recovery, In which case the only thing that will endthe austerity is blood on the streets in sufficient quantity to trigger chaosand a change in governance.” (ouremphasis)

And by the way, thenotion suggested by some that this horrible dynamic could be arrested by theFed acting as a kind of global central banker of last resort is asinine.   As BillMitchell noted recently:

Asof today, the 1 Euro = 1.3294 U.S. dollars. So just purchasing the PIIGS debtto fund their 2010 deficits would have required the US Federal Reserve sellaround 347,024 million USD which is about 5.8 per cent of the US GDP over thelast four quarters. That is a huge injection of US dollars into the worldforeign exchange markets.
Thevolume of spending that would be required are even larger than the estimatesprovided here. That is, because to really solve the Euro crisis the deficits in(probably) all the EMU nations have to rise substantially.
Whatdo you think would happen to the US dollar currency value? The answer is thatit would drop very significantly. The word collapse might be more appropriatethan drop…At this point in the crisis, there is nothing to be gained by a massiveUS dollar depreciation and the inflationary impulses such a large depreciationwould probably impart. 

Blaming the Fed for afailure to backstop the eurozone’s bonds is akin to blaming a bystander for notstanding in front of a bullet when he witnesses somebody taking out a gun, andshooting another person.  The triggermanbears ultimate responsibility.  By thesame token, the euro crisis is a crisis which has its roots in the eurozone’sflawed financial architecture (no less an authority than Jacques Delors hasrecently admitted this ), and can only be solved by theEuropeans, specifically, the ECB, which is the only institution in theEMU that can spend without recourse to prior funding, due to the flawed designof the monetary system that was forced upon the member states at the inceptionof the union.  But Mario Draghi acceptsthe German political quid pro quo: in order to act, he will insist on greaterfiscal austerity as a necessary condition, which will perversely have impact ofdeflating these economies into the ground further and engender HIGHER publicdeficits.  Obviously this is one reason the Germans felt socomfortable in naming an Italian to the ECB. Trojan horses apparently don’tjust come in Greek forms these days. A Europe, where countries such as Italyand Greece become client states of Germany provides a much more effectiveoutcome for Germany than, say, trying to do the same thing via anotherdestructive World War.