Greece and the Rest of the Eurozone Remain on the Road to Hell

By Marshall Auerback

So for the short term, it appears we won’t have a “Grexit”, which has led many commentators to suggest (laughably) that a crisis has been averted. Typical of this sentiment is a headline in Bloomberg today  “Greece avoids chaos; Big Hurdles Loom”. To paraphrase Pete Townsend, meet the new chaos, same as the old chaos. It is worth pondering how acceptance of the Troika’s program (even if cosmetic adjustments are made) will help hospitals get access to essential medical supplies (see here), whilst the government persists in enforcing a program which is killing its private sector by cutting spending and not paying legitimate bills, and an unemployment rate creeps towards 25 per cent and 50 per cent for youth. 

Prior to the June 17th vote, Greek voters were intimidated with a massive number of threats of what would happen if they didn’t vote “the right way” (i.e. anybody but the “radical leftists” in Syriza). Even then the conservatives on just led the vote count from their main anti-austerity rival. Amazingly, New Democracy leader Antonis Samaris suggested in his victory speech last night that the results reflected a vote for “growth.” There is more than a touch of Orwell at work when one can redefine the kinds of programs  which the Greeks will be forced to swallow as conducive to “growth” and “prosperity”.

So the Greek government will continue to plug away at austerity and the Troika will continue to pretend that such policies will ultimately lead to a Greek economic recovery. There will be some fake advertising about Europe making it easier on the Greeks, but it will be something without substance. Then things will get worse to the point where Samaras might have to take a helicopter to flee the crowds.

From the Opposition Syriza’s perspective this is not the worst outcome, since the 3rd place Pasok (Greece’s ostensible “socialist” party) is likely to join New Democracy (despite some posturing last night which suggested that they wouldn’t join a coalition in the absence of Syriza’s participation, thereby ensuring that all parties are tarred with these awful austerity policies). Then both Pasok and New Democracy will have to watch as Syrizai leads the opposition and probably wipes them out in another election within a year. Maybe even, within the year.

In the meantime nothing fundamental will change in Greece. It can’t, given that the circuits of credit in Greece are so badly damaged that even efficient, profitable firms have been cut out of the capital markets but also out of the international markets (their suppliers will no longer accept the Greek bank guarantees without which Greek firms cannot import raw materials, as Yanis Varoufakis has pointed out – see here). I asked Yanis why those profitable Greek businesses don’t simply shift their deposits to, say, a German bank, in order to get “reputable” letters of credit, and his response was that a German bank would simply not issue a guarantee on these businesses if they are registered in Greece.

The upshot will be that even profitable businesses will be forced to sell out to outside interests, after which the letters of credit will be forthcoming. If this isn’t an example of “hit man economics”, it’s hard to know what is.

As all of us on this blog have argued repeatedly, in the eurozone we have a solvency problem and a crisis of deficient aggregate demand. Unfortunately, within the European Monetary Union these twin crisis ultimately fall entirely in the realm of the issuer of the currency- the ECB, and not the users of the currency- the euro member nations. So without the ECB, directly or indirectly, underwriting the currency union, solvency is always an issue, whether that be Greece, Portugal, Spain, Italy or, indeed, Germany. Likewise deficient spending power has been exacerbated via the austerity imposed as a condition of the ECB’s help. It is akin to putting a patient on a drip feed, allowing him to recover, then breaking his legs again so that he remains bed-ridden.

And that includes the banking system, which, to serve public purpose, requires credible deposit insurance, again meaning support from the issuer of the currency. As our friend Warren Mosler has noted.

“The last few weeks have demonstrated that the ECB does ‘write the check’ for bank liquidity even though it’s not legally required to do that, (and even though some think it’s not acting within legal limits)

but it won’t just come out and say it.

And, apart perhaps from the Greek PSI (100 billion euro bond tax), which they still call ‘voluntary’,

no government has missed a payment, also with indirect ECB support either through bond buying

or via the banking system, but, again, it won’t just come out and say it’s an ongoing policy.”

So while the ECB has continued to underwrite the Greek (and now Spanish) banking systems, via all sorts of programs – LTRO, ELA, etc., the bank (and the member nations of the EMU) refuse to make explicit commitment of the kind that it will continue to backstop the system and thereby ensure its solvency – i.e. the long awaited “bazooka”. The ECB argues that this is a “fiscal role” which cannot be undertaken by the central bank, conveniently omitting the fact that there is no relevant fiscal authority in the Eurozone, which could take up this role. The ECB is the issuer of the currency and only they have the capacity to create unlimited quantities of euros. Paradoxically, by making this commitment explicit, they would find less need to use the “bazooka”, once the markets became convinced that they were serious. Instead, the ECB effectively plays poker with the markets by exposing its hand from the start, in effect encouraging speculators to persistently call their bluff.

Of course, nobody in Brussels actually acknowledges that the problem rests on the Eurozone’s fundamental architectural flaw (which is to say that there is no corresponding supranational fiscal authority), and they continue to castigate “profligate” governments, which run large budget deficits almost inevitably as a consequence of the collapse in private sector economic activity.

That has been the story of Greece, the rest of the European periphery and now the disease is spreading into the core (Dutch April retail sales were down 11% year-over-year, so this is no longer a “north vs south” problem in the euro zone). A good economy with rising public deficits and ECB support to keep it all going isn’t even a consideration at this point. They have painted themselves into an ideological corner, as Europe’s banking system continues to suffer from the throes of a massive bank run. The Greek election results won’t change that fact.

Contrary to arguments that she doesn’t “get it”, one has the sense from reading her recent remarks that German Chancellor Angela. Merkel actually does understand the nature of the problem.  More to the point, it is likely that she is also aware (via her economic advisors) of the extent of the Eurozone’s deposit run, which is now massive (probably in the trillions of euros). But to draw attention to the real problem risks highlighting Germany’s legal conundrum which we discussed in this piece:

It seems clear that the German Constitutional Court ruling on the Greek bailout in 2010 was quite explicit in terms of its meaning: According to this court ruling Target 2 and various other forms of the ECBs lender of last resort programs are unconstitutional, because they involve an open ended indeterminate exposure of the German people to losses involved in the bailout of the periphery. Yes, these are contingent liabilities, but the irony is that the more that Mrs. Merkel says “Nein” to any genuine proposal which could avert a solvency crisis, the more likely that these counterparty risks become real, rather than contingent. And the German parliament has no say in the disbursements.

And that’s just Target 2.  The deposit insurance program, which is now supposedly being discussed at the G-20 summit in Mexico represents a new initiative. That might be more readily challenged before the constitutional court as it is more readily understandable than the arcane and highly technical workings of, say, Target 2.. Chancellor Merkel may realize this. She may realize that a challenge to a deposit insurance initiative might bring to light the issue of the constitutionality of Target 2 and thereby threaten an even more intense run on the banks of the periphery of Europe.

So consider the following: there may well be a constitutional court challenge were the ECB to respond to the challenges posed by Greece and other members of the periphery via a deposit insurance scheme which they backstopped.  Unfortunately, the day that a court challenge happens and becomes public the bank run should accelerate greatly. regardless of the ultimate result.  If I’m a depositor in a Greek, Spanish or Italian bank and I think there is even the slightest possibility that an ECB-directed deposit insurance scheme could be nullified by a German court ruling, then I’ll raise to take my money elsewhere as quickly as I can.  No wonder the issue of capital controls is now being quietly discussed.

This is the real reason why Mrs Merkel says that there are limits to what Germany can do on its own and why she has continued to take such a hard line with Athens over the course of the Greek election campaign.. Of course, she rejects the alternatives because they are politically unpalatable, in part because she hasn’t been honest with her own electorate in spelling out what the real implications of Germany’s position is if the Eurozone blows up. She’s in a corner. This also explains why the Germans are so keen to involve entities like the IMF, because it helps get around this legal conundrum.

Back to Greece. it looks like the economic ‘torture chamber’ of mass unemployment can, operationally, persist indefinitely, even as, politically, it’s showing signs of coming apart. There has been increasing evidence in the last few weeks or so that suggest that the public deficits across the EU are propping up demand just enough to stop the currency union from blowing up.

But the actions of the Troika are neither politically desirable, nor sustainable over the longer term as the recent election results, not just in Greece, but all across Europe continue to demonstrate. Note that the Socialists claimed a huge majority in France’s Parliamentary elections held this past weekend, which suggests that the French too are getting fed up with the austerity led policies championed by Berlin.

Fiscal austerity of the kind imposed on Greece is in its death throes.   And thank goodness for that. Because if this form of Kevorkian economics continues, the crisis will surely spread to America’s shores, just at a time when the American ideological soulmates of Europe’s austerian brigade are seeking to shred what’s left of our own social safety net via a manufactured fiscal crisis. As the great Greek tragedian Euripides wrote, “”Whom the gods would destroy, they first make mad”

12 responses to “Greece and the Rest of the Eurozone Remain on the Road to Hell

  1. “According to this court ruling Target 2 and various other forms of the ECBs lender of last resort programs are unconstitutional, because they involve an open ended indeterminate exposure of the German people to losses involved in the bailout of the periphery. Yes, these are contingent liabilities, but the irony is that the more that Mrs. Merkel says “Nein” to any genuine proposal which could avert a solvency crisis, the more likely that these counterparty risks become real, rather than contingent. And the German parliament has no say in the disbursements.”

    Just revisiting this once again as it relates to the TARGET2 technical issues, I think much of the original push back against Sinn pertained to the interpretation of TARGET2 related credit risk.

    The opposing interpretation would be that the credit risk exposures of the TARGET2 surplus nations (e.g. Germany) are not determined by the TARGET2 positions per se. They are determined by the other side of the consolidated balance sheet of the Euro zone system of central banks.

    Add up all the stuff that’s on the asset side of all NCBs and the ECB balance sheet proper (netting out internal items across everything), assess the credit risk on it, and that’s the aggregate exposure. Any losses that ensure are for the joint account of the EZ 17, allocated according to ECB capital share.

    At a clinical accounting level, this balance sheet consolidation nets out all TARGET2 entries, so that TARGET2 balance distributions become irrelevant to the credit risk assessment per se.

    The loss sharing formula effectively bifurcates the liquidity measurement aspect of the overall TARGET2 configuration versus the credit risk allocation. On that basis, it is interesting that Germany is building up TARGET2 surplus balances, but that does not translate into a larger credit risk exposure for Germany than if the TARGET2 positions of France and Germany were switched for example.

    At least I think that was roughly the anti-Sinn argument.

    My question about all that would be whether the prospect of Eurozone unravelling actually puts Germany at risk with respect to the execution of that loss sharing formula. In other words, is there a scenario where losses that would otherwise be partially allocated to the weaker nations under the formula would boomerang instead back to Germany, so that it’s TARGET2 position does contingently become a measure of direct credit risk exposure as well. That would seem to be a legal contingency. And I think it is in that context that your basic question seems relevant. But apart from that, I see the credit risk exposure of Germany and the prospect of Sinn-like “stealth bailout” being already endorsed in the loss sharing formula of the ECB and the EZ 17.

    Does this make sense to you?

    The related point is that the aberrant TARGET2 distributions such as they’ve evolved become more of a symptom of the consolidated underlying ECB/NCB credit risk as opposed to an indicative allocation of that credit risk and potential losses. So yes, Germany and everybody else should be concerned at the building up of Bundesbank TARGET2 balances, simply because of what it suggests is happening to consolidated ECB/NCB credit risk underneath. Under the normal loss allocation formula, Germany and everybody else would be hurt in proportion.

    From there, the question becomes whether there is a contingent scenario under which Germany gets stuck with the full nominal amount of its own TARGET2 position as the indicative basis for the allocation of much more than its normal share of the credit losses in the system. And the probability of that contingency seems to get larger as the gross distribution of TARGET2 deficit positions gets larger across the system, indicating broad system weakness and the danger that nations simply won’t be able to or will be unwilling to absorb losses according to the existing share formula. Which again gets to a fundamental legal morass in some kind of EZ breakup scenario.

  2. JKH,
    You might well be right about what you say in regard to Target 2., but I’m not 100% convinced. My feeling is that the bank reserves are irrelevant here. A person moves a deposit from Santander to Commerzbank. So now, Commerzbank lends to the Bundesbank, which lends to the Bank of Spain with the ECB on the hook and the Bank of Spain then lending to the bank that lost the deposit (in this case, Santander). The two national central banks are subordinate to the ECB though the positions are on their balance sheets and not on the balance sheet of the ECB.

    My understanding is that the key is that net net the German banking system now has a loan to the ECB which has a lender of last resort loan to Spain. The issue of reserves are irrelevant here. The increase in the claim of the German banking system on the ECB and the ECB lender of last resort claim on the PIIGs is all that matters.

    If those positions grow into trillions of euros then the ECB is heavily compromised and in the end the Germans have a huge risk exposure. Reserves don;t matter.

    That said, my point is a much simpler one. Even if your characterisation of the system is correct, I think the Target 2 data, the huge increase in the ELA and other forms of ECB repo activity suggest that a deposit run is well and truly underway. Last Friday Chancellor Merkel said there is a limit as to how far Germany can go to support the periphery. Does that mean there is already a huge bank run and therefore huge German exposures to losses on ECB lender of last resort financings?

    So here’s my main point: Last year IFO head Hans Werner Sinn argued that Target 2 financing of the ECB was a joint euro area bailout of Europe’s periphery, putting it on par with Eurobonds. He has since argued that such financings are unconstitutional. Based on last year’s ruling of the constitutional court a case can be made that Target 2 has been unconstitutional.
    1) Target 2 financings are automatic.
    2) Target 2 financings are not clearly defined.
    3) There is no mechanism for reviews and decisions by the German parliament.
    If Target 2 is unconstitutional, joint euro area deposit insurance should be as well as it would fail to meet the above three criteria set out by the German Court last year.
    If anything, deposit insurance might be more likely to be unconstitutional than Target 2. It has been argued that Target 2 claims are on the ECB and are made within an established framework. The same might not be as readily argued for a new joint euro deposit insurance initiative.

    Now maybe they fight this out for years in the courts, if the joint euro deposit-insurance is challenged in the courts. But if I’m, say, a depositor at a Spanish bank and I think there is even a remote chance that all of the ECB’s lender of last resort financings are possibly unconstitutional, then I’m going to race to take my money out of a questionable bank. Chancellor Merkel may realize this. She may realize that a challenge to a deposit insurance initiative might bring to light the issue of the constitutionality of Target 2 and thereby threaten an even more intense run on the banks of the periphery of Europe.
    It may be these considerations that have so far delayed any move by the EU to arrest the current bank run with the only truly effective bazooka – jointly guaranteed insurance in euros for bank deposits in all euro member nations. That could leave us with a panic situation at some juncture. I guess that’s my main point.
    Does this make sense to you?

  3. JKH,

    “In other words, is there a scenario where losses that would otherwise be partially allocated to the weaker nations under the formula would boomerang instead back to Germany, so that it’s TARGET2 position does contingently become a measure of direct credit risk exposure as well.”

    “In other words, is there a scenario where losses that would otherwise be partially allocated to the weaker nations under the formula would boomerang instead back to Germany, so that it’s TARGET2 position does contingently become a measure of direct credit risk exposure as well.”

    Excellent points .

    First there is a potential trouble because it will be a politically difficult task for Germany to ask other governments to capitalize the ECB according to the formula if such a scenario arises. Even if it manages, it leaves other nations in a weaker state. So in a new scenario France can become Greece – to exaggerate a bit.

  4. Marshall,

    Largely makes sense to me, and happily there is nothing there that makes “no sense” to me. 🙂

    A few cross currents and details:

    – Not sure how you are interpreting how I would mean that “reserves matter”, but let’s leave that.

    – “I think the Target 2 data, the huge increase in the ELA and other forms of ECB repo activity suggest that a deposit run is well and truly underway.”

    Totally agree.

    – “If anything, deposit insurance might be more likely to be unconstitutional than Target 2. It has been argued that Target 2 claims are on the ECB and are made within an established framework. The same might not be as readily argued for a new joint euro deposit insurance initiative.”

    Yes – that’s the way I’m thinking about it in the context of your constitutionality theme.

    – “The increase in the claim of the German banking system on the ECB and the ECB lender of last resort claim on the PIIGs is all that matters.”

    This is one of the contentious points of detail regarding the entire Sinn debate earlier on, which I touched on in my first comment. According to the way in which loss sharing formula of the system is designed, the credit risk to Germany is not necessarily proportionate to its TARGET2 balance. Again, it doesn’t matter whether Germany or France has the TARGET2 balance. What matters is the underlying credit loss experience for the system as a whole.

    The question I have is whether the loss formula itself is subject to operational risk in ultimately distressed conditions. I agree with your analysis of how ECB refinancing operations increase ECB balance sheet risk and exposure, subject to my point that these are operationally separate from TARGET2. But the ECB loss sharing formula means that the risk is shared pro rata by everybody – hence my point about it not mattering to Germany whether Germany or France has the TARGET2 surplus balance – provided the loss sharing formula remains in place.

    The further point I made (which is really not critical to your constitutionality theme) is that Germany’s TARGET2 balance is not the source of funding for the ECB financing of the periphery that follows naturally from the initial TARGET2 transfer of deposits and reserves from one banking system to the other. These are two separate operations. The subsequent ECB reserve injection operations are a response to the prior TARGET2 operation whereby reserve liabilities were transferred from one central bank to another. The TARGET2 circuit loop starts with the deposit cum reserve migration from one banking system to another, and closes with the net TARGET2 entries between the two central banks involved via ECB intermediation. For example, TARGET2 It does not intersect operationally with subsequent reserve injections by the Bank of Greece (or Spain) or reserve withdrawals by the Bundesbank. Again – this is purely operational and descriptive only.

    – “But if I’m, say, a depositor at a Spanish bank and I think there is even a remote chance that all of the ECB’s lender of last resort financings are possibly unconstitutional, then I’m going to race to take my money out of a questionable bank.”

    I’m not saying you’re wrong here, but I’m really not clear on this. It’s one thing to suggest that the LLR function is unconstitutional. But again, LLR is operationally separate from TARGET2. Therefore, it seems to me that the constitutionality of LLR is actually a separate matter from the constitutionality of TARGET2. It is true that TARGET2 operational facilitation of deposit runs from Spain to Germany may well lead to ECB refinancing of Spanish banks. But they are still separate operations. So I guess I’m still not clear on exactly what it is that is subject to the constitutional issue. Furthermore, it seems odd to me that the constitutionality of the TARGET2 system should be questioned, if it is being questioned, because TARGET2 is the operational essence of the currency union. It allows a common currency to migrate around Europe in and out of different banking systems. It is the essence of the Euro, it seems to me. Therefore, it seems to me that the case for constitutional challenge of TARGET2 is ultra-weak, and that the case for constitutional challenge of the LLR function that arises as a natural operational consequence might be questionable on that basis. If there is a deposit/reserve flow out of Greece via TARGET2, then Bank of Greece refinancing operations may well be necessary to control interest rate levels for example. Turning all this upside down, if you challenge the constitutionality of TARGET2, then it seems to me you’re challenging the constitutionality of the entire Euro system that Germany joined.

    Moreover, what happens if either or both TARGET2 and LLR functions are declared unconstitutional? I.e. what is the operational consequence? It seems to me the currency union can no longer function. What do you do? So in particular I’m not sure what happens operationally in the event that either or both TARGET2 or LLR are declared unconstitutional, or how it affects Euro system operations going forward. Would be interested in your operational scenario on that. It suggests that there can’t be any clearing of Euro deposits from one area to another. So that has me scratching my head as a scenario outcome.

  5. It no longer is possible that euro nations do not understand the folly of the euro. Having given up their Monetary Sovereignty, the euro nations are doomed to deeper and deeper recessions. Having lost control over their money, they no longer have the tools to fight back.

    So they borrow. Visualize a guy with no job, borrowing from the Mafia, at higher and higher rates. His money crisis is solved for one day, only to be magnified the next.

    I first said this in a June 5th, 2005 talk at the University of Missouri, Kansas City: “Because of the Euro, no euro nation can control its own money supply. The Euro is the worst economic idea since the recession-era, Smoot-Hawley Tariff. The economies of European nations are doomed by the euro.”

    My only surprise is how long it has taken the mainstream media and economists even to begin to realize this. As for the euro leaders, they have another agenda. Austerity is the upper 1% (income’s) method for opening the income gap; austerity kills the 99%, but hardly bothers the 1%.

    The same is true in America, where the debt hawks do the bidding of the rich, by demanding reduced deficit spending, a guarantee for future recessions, where the rich open the income gap further.

    Rodger Malcolm Mitchell

  6. Samuel Conner

    Perhaps there is method to Frau Merkel’s madness. The longer the bank run proceeds, the higher the losses of the German banks in the event of periphexit. If these are sufficiently intolerable, what is now politically impossible for Germany may become politically necessary. An analogy might be the inadequate deficit spending measures in the US prior to WWII. The massive deficits needed to move toward full employment became politically necessary once the emergency was sufficiently dire.

  7. Marshall: “It seems clear that the German Constitutional Court ruling on the Greek bailout in 2010 was quite explicit in terms of its meaning: According to this court ruling Target 2 and various other forms of the ECBs lender of last resort programs are unconstitutional, because they involve an open ended indeterminate exposure of the German people to losses involved in the bailout of the periphery.”

    JKH: “Turning all this upside down, if you challenge the constitutionality of TARGET2, then it seems to me you’re challenging the constitutionality of the entire Euro system that Germany joined.
    Moreover, what happens if either or both TARGET2 and LLR functions are declared unconstitutional? I.e. what is the operational consequence? It seems to me the currency union can no longer function. What do you do? So in particular I’m not sure what happens operationally in the event that either or both TARGET2 or LLR are declared unconstitutional, or how it affects Euro system operations going forward. Would be interested in your operational scenario on that. It suggests that there can’t be any clearing of Euro deposits from one area to another. So that has me scratching my head as a scenario outcome.”

    That seems to be the crux of it. Under the German Constitutional Court ruling, it would seem that the structure of the currency union is unconstitutional under German law as presently. This would be comparable to SCOTUS declaring a treaty unconstitutional, therefore null and void?

    Is the solution to restructure the treaty to create a workable currency union by going to greater fiscal union. But the German high court has already weighed in on that, IIRC, and signaled that doing so would require a public referendum. The passage of a referendum that involves fiscal transfers from richer countries to poorer is questionable.

  8. I wish I were an economist, but this sounds like the Germans have declared bankruptcy uncontitutional. Good luck with that. And for our next trick we will outlaw hurricanes.

  9. Pingback: Grecia y el resto de la zona euro permanecen en el camino al infierno « Palabras Despiertas- MLC

  10. Vassilis Serafimakis

    No part of the above text, including the comments made about it, deserves to be famous and enter the economics lexicon than Marshall’s term for “Kevorkian economis”.
    I was trying to come up with something to denote the clearly suicidal policies followed by the Brussels-Berlin axis but all I had was the story told by Orson Welles’ character in “Mr Arkadin”, the one that ends with the toast “Here’s to character!”

  11. Vassilis Serafimakis

    No part of the above text, including the comments made about it, deserves to be famous and enter the economics lexicon than Marshall’s term for “Kevorkian economics”.
    I was trying to come up with something to denote the clearly suicidal policies followed by the Brussels-Berlin axis but all I had was the story told by Orson Welles’ character in “Mr Arkadin”, the one that ends with the toast “Here’s to character!”