Category Archives: Marshall Auerback

Greece: A Default is a Better Outcome Than the Deal on Offer

By Marshall Auerback

Pick your poison. In the words of Greek Finance Minister Evangelos Venizelos, the choice facing Greece today in the wake of its deal with the so-called “Troika” (the ECB, IMF, and EU) is “to choose between difficult decisions and decisions even more difficult. We unfortunately have to choose between sacrifice and even greater sacrifices in incomparably more dearly.”  Of course, Venizelos implied that failure to accept the latest offer by the Troika is the lesser of two sacrifices.  And the markets appeared to agree, selling off on news that the deal struck between the two parties was coming unstuck after weeks of building up expectations of an imminent conclusion. 
In our view, the market’s judgment is wrong:   an outright default might ultimately prove the better tonic for both Greece and the euro zone. 

The only questions that remain to be resolved are these: have all of the parties begun preparations to mitigate the ultimate impact of an outright default by Athens?  And will the ECB be sufficiently aggressive in combating the inevitable speculative attacks on the other members of the euro zone periphery, which are almost certain to ensue, once Greece is “resolved” one way or the other.
Within the Troika, the Germans in particular have been the champions of taking the toughest line possible against the Greeks and other “Mediterranean profligates”. But however stubborn Berlin appears to be, the Merkel Administration is certainly not stupid. At this juncture, it seems more rational to view their  ongoing promotion of fiscal austerity as a political smokescreen: In reality, what Germany likely wants to do in the case of Greece is trigger is an involuntary default so that the other PIIGS don’t get the wrong idea and ask for a similarly large haircut on their debts.  They realize the consequences that might follow, as the others gear up for similar treatment.  Far easier were Greece to move toward involuntary default, in the eyes of Berlin.
Politically, of course, the Merkel government can’t actually come out and advocate a Greek default or, indeed, outright expulsion from the euro zone. Far more politically astute to promote fiscal austerity on top of yet more fiscal austerity, (even though that is certainly not winning Mrs. Merkel any popularity points in Greece), until the Greeks themselves scream “Uncle!” and default outright.
It helps domestically as well. According to polls Angela Merkel is now the most popular politician in Germany, which is why she persists with this pernicious narrative that the problems of Greece all stem from fiscal profligacy and laziness, in contrast to the responsible and hard-working German people.
Ultimately, though an involuntary default carries risks for the stability of the euro payments system, a deal, per the terms outlined in the press, is bad for Greece.  And probably even worse for global markets, especially the bond markets.
Either eventuality creates problems but default is probably the less bad option longer term. Let me elaborate:
Greece is a hopelessly uncompetitive economy that probably shouldn’t be in the euro zone. But can you surgically detach Greece if it defaults, without some sort of impact on the entire euro payments system?

And what will the impact be on Greece itself?  The country currently runs a primary budget deficit (excluding interest payments on debt) of around 5% of GDP. Were it to default, Athens would be forced to go cold turkey (“cold Greece”?) until the primary fiscal deficit (now around 5% of GDP) is balanced. Maybe the government could suspend all military expenditures as a first pass? At the very least, they can stop buying German military equipment!
No question, that under a default, a lot of public sector employees will be sacked, pensions will be at risk, and unemployment will almost certainly go higher.  But that is certainly going to occur under the deal now being struck.   Were the country to revert to the drachma, however, they would likely be left with a substantially weaker currency, which could ultimately provide the country with the wherewithal to compete in the global economy. With a super-cheap exchange rate, Greece could become a Mecca for retirement homes, research hospitals, trans-European liberal arts colleges, and maybe low-overhead software startups. Plus, a permanent home for the Olympics. It could live happily ever after, as Florida does, on the pension income of the elderly and the beer money of the young.
This would be the source of the foreign transfers that the private banking sector won’t make anymore. In Greece’s case that credit went to the public sector and a lot of it built useful infrastructure, so it’s not a waste, but the first step is surely to cancel the debts and stop the illusion that they can be paid. And it would end the “death by 1000 cuts” currently being imposed on the Troika, which will serve no useful economic, political or social purpose.
Of course, there will be a slew of defaults and an endless series of court cases, litigation, etc., much as there was when Argentina defaulted in 2001.  But it would force the issue of debt restructuring on the table in a meaningful way and at least provide Greece with light at the end of the tunnel.
To ensure some sort of viability of the drachma, the Greek government would have to find a more credible means of ensuring tax compliance. Most Greeks with money have presumably already moved it beyond the reach of the Greek banking system, so that savings would not be wiped out. As the tide of repossessions begins, many of these oligarchs would likely start to buy back the Greek assets on the cheap, as it is doubtful that the euro banks will want anything to with them.
Beyond that, it would be important for Athens to establish a new tax system that minimises tax evasion, so as to create demand for the new drachma immediately, and mitigate the formation of an extensive parallel transactions currency. After all, it is possible that many Greeks might prefer to use the existing stock of euros in the country and there is very little the EU authorities could do to stop this (much as the US government could not prevent Panama from dollarising its economy). But in order to establish a long-lasting demand for drachmas, two things would have to happen: 
  1. The Greek government would announce that it will begin taxing exclusively in the new currency.
  2. The Greek government would announce that it will make all payments in the new currency. 

Given the country’s history of tax evasion on income tax, a national real estate tax would likely work better than a new income tax.
(See here for more details:)

On the other hand, the challenge for the European Union authorities is to ensure that speculative capital is not unleashed on the next weakest link in the chain – say, Portugal – to ensure that there is an adequate firewall established and to minimise disruptions to the entire euro payments system. It’s unclear to me whether the euro zone authorities have truly thought this aspect through and considered the best means to prevent a major disruption of the EMU payments system. Then again, perhaps this is what the ECB’s new programs are really all about.

On the other hand, I happen to think a rescue of the sort that is now being publicly mooted is worse for both sides. The imposition of yet more fiscal austerity on Greece will exacerbate the debt deflation dynamics which are destroying the country and will provide Greece with ZERO means of servicing even the reduced levels of debt. The country will still remain uncompetitive and depression like conditions will continue, with the ongoing burden of more euro denominated debt servicing.
More dangerous is the risk that comes if there is a “successful” deal: It come with the pending question- ‘if Greece doesn’t have to pay, why do I’- The Irish are asking that question already, and I’m sure the Portuguese and Spanish will soon be asking the same thing. As my friend Warren Mosler has noted: 

Possible immediate consequences of that discussion include a sharp spike in gold, silver, and other commodities in a flight from currency, falling equity and debt valuations, a banking crisis, and a tightening of ‘financial conditions’ in general from portfolio shifting, even as it’s fundamentally highly deflationary. And while it probably won’t last all that long, it will be long enough to seriously shake things up.

Longer term, a Greek default could well provoke the question, “What on earth do governments issue bonds for anyway?” That might well provoke a far more provocative debate on the nature of modern money and the self-imposed legal constraints with which sovereign governments bind themselves in their conduct of fiscal policy. But that’s probably best left to the pages of another blog post!

Greece and the Rape by the Rentiers

Here’s the draft of the supposed agreement to “sort out” the Greek debt problem once and for all. According to Bloomberg, here are the essentials:

  • Greece’s 2012 GDP will shrink by as much as 5%.
  • Greece is expected to return to growth in 2013.
  • Greece will cut 15,000 state jobs in 2012.
  • Minimum wage will be cut by 20 percent.
  • There will be no increase to sales tax.
  • The government will cut medicine spending from 1.9% to 1.5% and merge all auxiliary pension funds.
  • It will also sell stakes in six companies—in particular, energy companies and refineries.

Of course, the current thrust of fiscal policy will almost certainly guarantee that there still will be a default, involuntary or otherwise, in spite of this agreement. If you don’t have a mechanism to allow growth, then how can the Greeks service their debt, even with the reduced debt burden?

Perhaps that’s the idea. Make the deal so miserable for the Greek people that the Spanish, Portuguese, Irish and Italians don’t even begin to think of trying to get a similar haircut on their debt.
Certainly, the deficit reduction won’t come. It can’t when you deflate a rapidly declining economy into the ground. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies.

Even with all of the concessions, the euro bosses have not officially signed off on the agreement:

* Finance ministers of the 17-nation euro zone arriving for talks in Brussels warned there would be no immediate green light for the rescue package and said Athens must prove itself first. 

* “It’s up to the Greek government to provide concrete actions through legislation and other actions to convince its European partners that a second program can be made to work,” EU Economic and Monetary Affairs Commissioner Olli Rehn said. 

* German Finance Minister Wolfgang Schaeuble, whose country is Europe’s biggest paymaster, told reporters: “You don’t need to wait around because there will be no decision (tonight).” 

* Greek Finance Minister Evangelos Venizelos flew to Brussels after all-night talks involving Prime Minister Lucas Papademos, leaders of the three coalition parties and chief EU and IMF inspectors left one sensitive issue – pension cuts – unresolved.

It is also worth pointing out that Greece’s pension payments on a per capita basis are amongst the lowest in Europe. Still, apparently, this plunder hasn’t gone far enough The Greek people must feel like Sabine Women right now.

Game, set and match to the Troika.
While we’re at it, let’s address this “Greeks as tax cheats” canard once and for all. Greece’s tax revenue from VAT collapsed by 18.7pc in January from a year earlier. As Ambrose Evans Pritchard noted:

“Nobody can seriously blame tax evasion for this. It has happened because 60,000 small firms and family businesses have gone bankrupt since the summer. 

The VAT rate for food and drink rose from 13pc to 23pc in September to comply with EU-IMF Troika demands. The revenue effect has been overwhelmed by the contraction of the economy.
Overall tax receipts fell 7pc year-on-year.”

We’re one step closer to ensuring that the birthplace of democracy becomes a form of national indentured servitude. That is of course, unless Greece regains some modicum of self-respect and tells the Troika to take a hike and leaves the euro zone.

The Elephant in the Room is Spain, Not Italy

By Marshall Auerback

Another day andthe markets remain fixated on whether Greece comes to a “voluntary” arrangementwith its creditors.  The key word is“voluntary” because the myth of “voluntary compliance has to be sustained sothat those deadly credit default swaps avoid being triggered. 
But let’s faceit:  Greece is a pimple.  If the rest of the euro zone could cut itlose with a minimum of systemic risk, Athens would have long gone the way ofTroy.  The real issue is whether thecredit default swaps trigger such a huge mess with the counterparties that itcreates renewed systemic stress which more than offsets the benefits to theholders of the CDSs. 
The moreinteresting question is:  suppose Greece finally does get a deal?  Irealize everybody says it is a “one-off”, but do you really think theIrish, Portuguese, or even the Spanish and Italians will go along with that,particularly if (as is likely) they continue to experience double digitunemployment and minimal growth?
Now you could argue thatPortugal and Ireland, like Greece, are but small components of the EuropeanUnion and could well be covered in one form or another via the existingbackstops established over the last several months, notably the EuropeanFinancial Stability Fund (EFSF) and the European Stability Mechanism(ESM). 
But you can’t say this aboutSpain, which remains the real elephant in the room – not Italy – even thoughSpain’s borrowing costs remain lower than Italy’s. This is perverse. 
Though Italy has a highsovereign debt, it has a low private debt (the product of years of high budgetdeficits, but that’s the story for another blog). Italy has a fiscal deficitthat is low relative to most economies today. It already has a primary surplus.The greater than expected past expansion of the ESCB and the current ongoingLTROs are likely to absorb panic and forced selling of Italian debt. TheItalian 10-year yield could fall back below 5% (having already fallen from the 7%plus levels, pertaining a mere 6 weeks ago).

In theory, this rally in bond yields should lead to a reassessment of thegravity of the Italian problem and therefore the European sovereign debt andbanking problem. That could be positive for equity markets and, indeed, hasbeen so since the start of the year. 

But does Spain truly deserve theborrowing advantage it now has in relation to Italy?  Its 10-year bonds are yielding some 60 basispoints lower. True, its sovereign debt to GDP ratio is low at about 75%, but partof its enormous private debt will almost certainly have to be “socialized.”  Moreover, Spain has virtually the highestnon-financial private debt-to-GDP ratio of all the major economies.  Its ratio is almost twice that of Italy’s. Itsfiscal deficit last year was probably higher than the official estimates, closeto 9% of GDP (the previous Socialist government routinely lied about itsfigures – in fact, no country, not even the US, has lied more extensively aboutthe condition of its banks.  Spain, relative to GDP, has the largestshadow real estate inventory in the world, with the possible exception ofChina, which probably doesn’t even have a reliable second or third set ofbooks).

Let’s be clear about onething:  this is not a tale of Mediterranean“profligacy”, as least as far as public spending was concerned.  Anybody looking at Spain through a sensiblefinancial balances framework in the mid-2000s would have observed that theprivate sector was being squeezed badly by the fiscal drag. The externalposition was in deficit (current account) which means the public and externalbalances were draining growth from the economy. Yet it still boomed up into theonset of the crisis. How did that happen?

The profligates were all in theprivate sector, although you could readily argue that the government’s“responsible” fiscal policy created the conditions for a private sector debtbinge.
  Prior to 2008, the Spanisheconomy was held out as the darling of Europe however the reality was quitedifferent. The country was running budget surpluses by 2005 and foreigninvestment was booming. Most of this investment went into construction whichwas stimulated by a massive real estate boom.

A few years ago, using data fromData from the Banco de España (central bank) Bill Mitchell graphed the nationalbudget deficit as a percentage of GDP for Spain and the EMU overall from 1989to 2008 (data for the EMU clearly didn’t start until 1995). As Mitchell
notes,one can observe the tightening of fiscal positions as the Growth and StabilityPact provisions were forced on the EMU nations:

EMU and Spain: Budget deficit % of GDP,1989 to 2008

Consistent with a tighteningfiscal position leading to surpluses in 2005, the only way that this boom couldcontinue was for the private sector to go increasingly into debt.That is exactly what happened and because the property boom was so large thedebt levels were also very high – average household debt tripled. And that, incontrast to Italy, is the core problem with which Spain is dealing today to asubstantially greater degree than Italy. So it’s wrong to lump the two together interchangeably as the marketshave been doing.  Paella and pasta don’tmix well together.

Okay, but that was the previousZapatero
Administration.  Now we supposedly have a new “responsible” conservativegovernment that promises to carry out the same policies even moreresolutely.  And look how successfulthey’ve been:  Spain’s joblessclaims shot up a further 4% in January from December to 4.59 million, a signthat the euro zone’s fourth-largest economy is still shedding jobs at a recordrate. All sectors posted more claims but the rise was sharpest for services at5.1%. In construction, weighed down by a four-year property slump, the numberof residents registered as job seekers rose 2.1%. Compared with the same perioda year ago, overall claims rose 8%.  GDPcontracted 0.3%.  

Okay,“give them time”, argue the defenders of the new government.  And, if the Rajoy Administration was trulyembarking on a new policy course, that would be a fair comment.  Unfortunately, this government has signed onto even tighter fiscal policy rules.
Somehowthey are expected to suck demand out of their economies through tax increasesand spending cuts, but when the slower growth that results in means the targetfor deficit reduction is not met, the Spanish, like their Greek, Irish,Portuguese and Italian counterparts, will be punished for it.

Eventhe Rajoy Administration implicitly appears to recognize this danger, as it isalready moving the goalposts in regard to its spending cuts targets as apercentage of GDP.  Unfortunately, theyblame this on external circumstances beyond their control. To the extent thatthey agree to submit themselves to rules which were routinely disobeyed by theGermans and French during the EMU’s inception, that is true, although theSpanish government refuses to acknowledge that their resolute tightening fiscalpolicy ex ante might well have something to do with the fact that Spain’seconomy continues to deflate into the ground ex post.  Remember,
thehistory of the Stability and Growth Pact has long demonstrated that thesenonsensical rules are already impossible to keep within during a significantdownturn. And now the new Spanish government wants to tighten them even furtherand invoke pro-cyclical fiscal reactions earlier.
This, at a time when the nationalunemployment rate is approaching 23%, and the youth unemployment rate (25 yearsor younger) is at 49%, according to the latest Eurostat data.

Sonearly 50 per cent of willing workers under the age of 25 in Spain are withoutwork and will remain like that for years to come. That will damage productivitygrowth for the next decade or more. It is an indication that the monetarysystem has failed and attempting to reinforce those failures with moreausterity will only make matters worse.  The new government’s proposed fiscal policy “reforms” areparticularly toxic policy mixture for Spain.

Of course, the ongoing threat ofa disorderly default in Greece also remains a potentially dangerous areaif it is not contained by the ECB’s actions.
 But it’s more interesting to see what happens as the magnitude ofSpain’s problems become more apparent.  Will the troika tell Spain that a Greek style70% haircut is not in the cards?  Willthey try to suggest that the government is rife with corruption, that thecountry is chock-a-block full of scoff-laws and tax evaders, and that theefficient Germans would do a much better job of collecting taxes?

Spain is still a relatively youngdemocracy.
  The transition began a mere37 years ago when Francisco Franco died in 1975, but there was an attemptedcoup by Antonio Tejero as recently as 1981. This is worth pondering whilst observing the implosion of Spain’seconomy. The decision for Europe’s bosses is this: they must ultimately confront theconsequences of their policy choices. They can destroy the eurozone by continuing with the same failed mix ofpolicies or by salvaging it by adding what has been missing from the outset: amechanism for shifting surpluses to the deficit regions in the form ofproductive investments(as opposed to handouts or loans). Turning stateslike Spain into sundrenched economic wastelands within the eurozone, andforcing the rest of the currency area into a debt-deflationary spiral, is amost efficient way of blowing up the whole system and possibly threatening thevery existence of Spanish liberal democracy itself.

US Employment Growth Shows Fiscal Policy Matters

By Marshall Auerback

US Q4 2011 GDP growth was slightly disappointing, and the mix was terrible as the growth was mostly due to inventories. I took issue with that report, arguing that the weakness was due to statistical distortions in the government spending data and the PCE services data. With that disappointing Q4 GDP report, expectations for quite weak economic growth in this year’s first half were encouraged.

But today’s employment data blows the weak consensus outlook out of the water. The economy created jobs at the fastest pace in nine months in January and the unemployment rate dropped to a near three-year low of 8.3 percent, indicating last quarter’s growth carried into early 2012.

Continue reading

Marshall Auerback’s Latest Interview on the Euro Crisis

Marshall’s latest take on the state of the Euro crisis can be found here.  For those following the situation there, you won’t want to miss this.

Anschluss Economics – The Germans Launch A Blitzkrieg on the Greek Debt Negotiations

News stories continue to suggest that Greeceonce again appears on the verge of reaching a deal with its private sectorcreditors on how much of a loss they would be willing to accept on their bondholdings. The latest numbers suggest a 70% write-down. A pretty strikingcomedown for what is supposed to be a “voluntary default” and, hence,not subject to the triggers of a credit default swap on Greek debt.
Naturally, the spin surrounding the proposedagreement is that this is a “one-off” and that other troubledperiphery nations shouldn’t even begin to think of securing a comparable deal.But the inherent tension between securing a write-down on Greek debt which moreclosely mirrors the disaster which is now the Greek economy, and the desire tominimise the potential contagion effect is rearing its ugly head already, andmay help to explain some of Germany’s recent machinations.

Marshall Auerback discusses the Euro on the Lang and O’Leary Exchange.  Watch it here.

Solvency Starts with the ECB

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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.

Marshall Auerback on BNN: What’s Europe’s Next Step?

Marshall Auerback discusses the latest in Euro woes and the possibility of it spreading beyond the Eurozone.  In the first clip Marshall stresses the need for ECB intervention to calm the onset of a debt-deflation dynamic.  In the second, he follows up on the likelihood that the crisis will spread to sovereign currency nations like the US, where he explains that insolvency is not a threat.