Tag Archives: debt crisis

The Debt Crisis in Puerto Rico: Why Is It Not More Newsworthy?

By Robert E. Prasch

Anyone who follows the news periodically, if not more often, wonders about the criteria making certain issues or persons “newsworthy,” and others substantially less so. One reliable indicator of newsworthiness is that the story happens in Washington, D.C. A second is an unusual or counter-intuitive event (“Man bites dog”). A third is the prospect of large losses. This last quality, however, renders the relative neglect of Puerto Rico’s debt crisis an interesting anomaly.

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Mario vs. Mariano Could Mean the End of Spain

By Marshall Auerback

The real weak link now in the Eurozone is Spain, where the data is a disaster. It is Greece writ large. And this is before Madrid, under Prime Minister Mariano Rajoy, has submitted to a new ECB program of agreed austerity in exchange for the ECB backstopping the nation’s bonds via a renewed Securities Market Program (SMP).

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Europe’s Transition From Social Democracy to Oligarchy

By Michael Hudson
This article was first published by Frankfurter Allgemeine Zeitung, Dec. 3, 2011, as “Der Krieg der Banken gegen das Volk.

The easiest way to understandEurope’s financial crisis is to look at the solutions being proposed to resolveit. They are a banker’s dream, a grab bag of giveaways that few voters would belikely to approve in a democratic referendum. Bank strategists learned not torisk submitting their plans to democratic vote after Icelanders twice refusedin 2010-11 to approve their government’s capitulation to pay Britain and theNetherlands for losses run up by badly regulated Icelandic banks operatingabroad. Lacking such a referendum, mass demonstrations were the only way forGreek voters to register their opposition to the €50 billion in privatizationsell-offs demanded by the European Central Bank (ECB) in autumn 2011.
The problemis that Greece lacks the ready money to redeem its debts and pay the interestcharges. The ECB is demanding that it sell off public assets – land, water andsewer systems, ports and other assets in the public domain, and also cut backpensions and other payments to its population. The “bottom 99%” understandablyare angry to be informed that the wealthiest layer of the population  is largely responsible for the budgetshortfall by stashing away a reported €45 billion of funds stashed away inSwiss banks alone. The idea of normal wage-earners being obliged to forfeittheir pensions to pay for tax evaders – and for the general un-taxing of wealthsince the regime of the colonels – makes most people understandably angry. Forthe ECB, EU and IMF “troika” to say that whatever the wealthy take, steal orevade paying must be made up by the population at large is not a politicallyneutral position. It comes down hard on the side of wealth that has beenunfairly taken.
A democratictax policy would reinstate progressive taxation on income and property, andwould enforce its collection – with penalties for evasion. Ever since the 19thcentury, democratic reformers have sought to free economies from waste,corruption and “unearned income.” But the ECB “troika” is imposing a regressivetax – one that can be imposed only by turning government policy-making over toa set of unelected “technocrats.”
Tocall the administrators of so anti-democratic a policy “technocrats” seems tobe a cynical scientific-sounding euphemism for financial lobbyists orbureaucrats deemed suitably tunnel-visioned to act as useful idiots on behalfof their sponsors. Theirideology is the same austerity philosophy that the IMF imposed on Third Worlddebtors from the 1960s through the 1980s. Claiming to stabilize the balance ofpayments while introducing free markets, these officials sold off exportsectors and basic infrastructure to creditor-nation buyers. The effect was todrive austerity-ridden economies even deeper into debt – to foreign bankers andtheir own domestic oligarchies.
Thisis the treadmill on which Eurozone social democracies are now being placed.Under the political umbrella of financial emergency, wages and living standardsare to be scaled back and political power shifted from elected government totechnocrats governing on behalf of large banks and financial institutions.Public-sector labor is to be privatized – and de-unionized, while SocialSecurity, pension plans and health insurance are scaled back.
Thisis the basic playbook that corporate raiders follow when they empty outcorporate pension plans to pay their financial backers in leveraged buyouts. Italso is how the former Soviet Union’s economy was privatized after 1991, transferringpublic assets into the hands of kleptocrats, who worked with Western investmentbankers to make the Russian and other stock exchanges the darlings of theglobal financial markets. Property taxes were scaled back while flat taxes wereimposed on wages (a cumulative 59 percent in Latvia). Industry was dismantledas land and mineral rights were transferred to foreigners, economies driveninto debt and skilled and unskilled labor alike was obliged to emigrate to findwork.
Pretendingto be committed to price stability and free markets, bankers inflated a realestate bubble on credit. Rental income was capitalized into bank loans and paidout as interest. This was enormously profitable for bankers, but it left theBaltics and much of Central Europe debt strapped and in negative equity by2008. Neoliberals applaud their plunging wage levels and shrinking GDP as asuccess story, because these countries shifted the tax burden onto employmentrather than property or finance. Governments bailed out banks at taxpayerexpense.
Itis axiomatic that the solution to any major social problem tends to create evenlarger problems – not always unintended! From the financial sector’s vantagepoint, the “solution” to the Eurozone crisis is to reverse the aims of theProgressive Era a century ago – what John Maynard Keynes gently termed“euthanasia of the rentier” in 1936.The idea was to subordinate the banking system to serve the economy rather thanthe other way around. Instead, finance has become the new mode of warfare –less ostensibly bloody, but with the same objectives as the Viking invasionsover a thousand years ago, and Europe’s subsequent colonial conquests:appropriation of land and natural resources, infrastructure and whatever otherassets can provide a revenue stream. It was to capitalize and estimate suchvalues, for instance, that William the Conqueror compiled the Domesday Bookafter 1066, a model of ECB and IMF-style calculations today.
Thisappropriation of the economic surplus to pay bankers is turning the traditionalvalues of most Europeans upside down. Imposition of economic austerity,dismantling social spending, sell-offs of public assets, de-unionization oflabor, falling wage levels, scaled-back pension plans and health care incountries subject to democratic rules requires convincing voters that there isno alternative. It is claimed that without a profitable banking sector (nomatter how predatory) the economy will break down as bank losses on bad loansand gambles pull down the payments system. No regulatory agencies can help, nobetter tax policy, nothing except to turn over control to lobbyists to savebanks from losing the financial claims they have built up.
What banks wantis for the economic surplus to be paid out as interest, not used for risingliving standards, public social spending or even for new capital investment.Research and development takes too long. Finance lives in the short run. Thisshort-termism is self-defeating, yet it is presented as science. Thealternative, voters are told, is the road to serfdom: interfering with the“free market” by financial regulation and even progressive taxation.
Thereis an alternative, of course. It is what European civilization from the 13th-centurySchoolmen through the Enlightenment and the flowering of classical politicaleconomy sought to create: an economy free of unearned income, free of vestedinterests using special privileges for “rent extraction.” At the hands of theneoliberals, by contrast, a free market is one free for a tax-favored rentierclass to extract interest, economic rent and monopoly prices.
Rentier interests present their behavioras efficient “wealth creation.” Business schools teach privatizers how toarrange bank loans and bond financing by pledging whatever they can charge forthe public infrastructure services being sold by governments. The idea is topay this revenue to banks and bondholders as interest, and then make a capitalgain by raising access fees for roads and ports, water and sewer usage andother basic services. Governments are told that economies can be run moreefficiently by dismantling public programs and selling off assets.
Neverhas the gap between pretended aim and actual effect been more hypocritical.Making interest payments (and even capital gains) tax-exempt deprives governmentsof revenue from the user fees they are relinquishing, increasing their budgetdeficits. And instead of promoting price stability (the ECB’s ostensiblepriority), privatization increases prices for infrastructure, housing and othercosts of living and doing business by building in interest charges and otherfinancial overhead – and much higher salaries for management. So it is merely aknee-jerk ideological claim that this policy is more efficient simply becauseprivatizers do the borrowing rather than government.
Thereis no technological or economic need for Europe’s financial managers to imposedepression on much of its population. But there is a great opportunity to gainfor the banks that have gained control of ECB economic policy. Since the 1960s,balance-of-payments crises have provided opportunities for bankers and liquidinvestors to seize control of fiscal policy – to shift the tax burden ontolabor and dismantle social spending in favor of subsidizing foreign investorsand the financial sector. They gain from austerity policies that lower livingstandards and scale back social spending. A debt crisis enables the domesticfinancial elite and foreign bankers to indebt the rest of society, using theirprivilege of credit (or savings built up as a result of less progressive taxpolicies) as a lever to grab assets and reduce populations to a state of debtdependency.
Thekind of warfare now engulfing Europe is thus more than just economic in scope.It threatens to become a historic dividing line between the past half-century’sepoch of hope and technological potential to a new era of polarization as afinancial oligarchy replaces democratic governments and reduces populations todebt peonage.
For so boldan asset and power grab to succeed, it needs a crisis to suspend the normalpolitical and democratic legislative processes that would oppose it. Politicalpanic and anarchy create a vacuum into which grabbers can move quickly, usingthe rhetoric of financial deception and a junk economics to rationalizeself-serving solutions by a false view of economic history – and in the case oftoday’s ECB, German history in particular.
A central bank that is blocked from acing like one
Governmentsdo not need to borrow from commercial bankers or other lenders. Ever since theBank of England was founded in 1694, central banks have printed money tofinance public spending. Bankers also create credit feely – when they make aloan and credit the customer’s account, in exchange for a promissory notebearing interest. Today, these banks can borrow reserves from the governmentcentral bank at a low annual interest rate (0.25% in the United States) andlend it out at a higher rate. So banks are glad to see the government’s centralbank create credit to lend to them. But when it comes to governments creatingmoney to finance their budget deficits for spending in the rest of the economy,banks would prefer to have this market and its interest return for themselves.
Europeancommercial banks are especially adamant that the European Central Bank shouldnot finance government budget deficits. But private credit creation is notnecessarily less inflationary than governments monetizing their deficits(simply by printing the money needed). Most commercial bank loans are madeagainst real estate, stocks and bonds – providing credit that is used to bid uphousing prices, and prices for financial securities (as in loans for leveragedbuyouts).
Itis mainly government that spends credit on the “real” economy, to the extentthat public budget deficits employ labor or are spent on goods and services. Ifgovernments avoid paying interest by having their central banks printing moneyon their own computer keyboards rather than borrowing from banks that do thesame thing on their own keyboards. (Abraham Lincoln simply printed currencywhen he financed the U.S. Civil War with “greenbacks.”)
Bankswould like to use their credit-creating privilege to obtain interest forlending to governments to finance public budget deficits. So they have aself-interest in limiting the government’s “public option” to monetize itsbudget deficits. To secure a monopoly on their credit-creating privilege, bankshave mounted a vast character assassination on government spending, and indeedon government authority in general – which happens to be the only authoritywith sufficient power to control their power or provide an alternative publicfinancial option, as Post Office savings banks do in Japan, Russia and othercountries. This competition between banks and government explains the falseaccusations made that government credit creation is more inflationary than whencommercial banks do it.
Thereality is made clear by comparing the ways in which the United States, Britainand Europe handle their public financing. The U.S. Treasury is by far theworld’s largest debtor, and its largest banks seem to be in negative equity,liable to their depositors and to other financial institutions for much largersums that can be paid by their portfolio of loans, investments and assortedfinancial gambles. Yet as global financial turmoil escalates, institutionalinvestors are putting their money into U.S. Treasury bonds – so much that thesebonds now yield less than 1%. By contrast, a quarter of U.S. real estate is innegative equity, American states and cities are facing insolvency and mustscale back spending. Large companies are going bankrupt, pension plans arefalling deeper into arrears, yet the U.S. economy remains a magnet for globalsavings.
Britain’seconomy also is staggering, yet its government is paying just 2% interest. ButEuropean governments are now paying over 7%. The reason for this disparity isthat they lack a “public option” in money creation. Having a Federal Reserve Bankor Bank of England that can print the money to pay interest or roll overexisting debts is what makes the United States and Britain different fromEurope. Nobody expects these two nations to be forced to sell off their publiclands and other assets to raise the money to pay (although they may do this asa policy choice). Given that the U.S. Treasury and Federal Reserve can createnew money, it follows that as long as government debts are denominated indollars, they can print enough IOUs on their computer keyboards so that theonly risk that holders of Treasury bonds bear is the dollar’s exchange ratevis-à-vis other currencies.
Bycontrast, the Eurozone has a central bank, but Article 123 of the Lisbon treatyforbids the ECB from doing what central banks were created to do: create themoney to finance government budget deficits or roll over their debt fallingdue. Future historians no doubt will find it remarkable that there actually isa rationale behind this policy – or at least the pretense of a cover story. Itis so flimsy that any student of history can see how distorted it is. The claimis that if a central bank creates credit, this threatens price stability. Onlygovernment spending is deemed to be inflationary, not private credit!
TheClinton Administration balanced the U.S. Government budget in the late 1990s,yet the Bubble Economy was exploding. On the other hand, the Federal Reserveand Treasury flooded the economy with $13 trillion in credit to the bankingsystem credit after September 2008, and $800 billion more last summer in theFederal Reserve’s Quantitative Easing program (QE2). Yet consumer and commodityprices are not rising. Not even real estate or stock market prices are beingbid up. So the idea that more money will bid up prices (MV=PT) is not operatingtoday.
Commercialbanks create debt. That is their product. This debt leveraging was used formore than a decade to bid up prices – making housing and buying a retirementincome more expensive for Americans – but today’s economy is suffering fromdebt deflation as personal income, business and tax revenue is diverted to paydebt service rather than to spend on goods or invest or hire labor.
Muchmore striking is the travesty of German history that is being repeated againand again, as if repetition somehow will stop people from remembering whatactually happened in the 20th century. To hear ECB officials tellthe story, it would be reckless for a central bank to lend to government,because of the danger of hyperinflation. Memories are conjured up of the Weimarinflation in Germany in the 1920s. But upon examination, this turns out to bewhat psychiatrists call an implanted memory – a condition in which a patient isconvinced that they have suffered a trauma that seems real, but which did notexist in reality.
Whathappened back in 1921 was not a case of governments borrowing from centralbanks to finance domestic spending such as social programs, pensions or healthcare as today. Rather, Germany’s obligation to pay reparations led theReichsbank to flood the foreign exchange markets with deutsche marks to obtainthe currency to buy pounds sterling, French francs and other currency to paythe Allies – which used the money to pay their Inter-Ally arms debts to theUnited States. The nation’s hyperinflation stemmed from its obligation to payreparations in foreign currency. No amount of domestic taxation could haveraised the foreign exchange that was scheduled to be paid.
Bythe 1930s this was a well-understood phenomenon, explained by Keynes and otherswho analyzed the structural limits on the ability to pay foreign debt imposed without regard for the ability to pay out ofcurrent domestic-currency budgets. From Salomon Flink’s The Reichsbank and Economic Germany (1931) to studies of theChilean and other Third World hyperinflations, economists have found a commoncausality at work, based on the balance of payments. First comes a fall in theexchange rate. This raises the price of imports, and hence the domestic pricelevel. More money is then needed to transact purchases at the higher pricelevel. The statistical sequence and lineof causation leads from balance-of-payments deficits to currency depreciationraising import costs, and from these price increases to the money supply, not the other way around.
Today’s“free marketers” writing in the Chicago monetarist tradition (basically that ofDavid Ricardo) leaves the foreign and domestic debt dimensions out of account.It is as if “money” and “credit” are assets to be bartered against goods. But abank account or other form of credit means debt on the opposite side of thebalance sheet. One party’s debt is another party’s saving – and most savingstoday are lent out at interest, absorbing money from the non-financial sectors of the economy. The discussion isstripped down to a simplistic relationship between the money supply and pricelevel – and indeed, only consumer prices, not asset prices. In their eagernessto oppose government spending – and indeed to dismantle government and replaceit with financial planners – neoliberal monetarists neglect the debt burdenbeing imposed today from Latvia and Iceland to Ireland and Greece, Italy, Spainand Portugal.
Ifthe euro breaks up, it is because of the obligation of governments to pay bankersin money that must be borrowed rather than created through their own centralbank. Unlike the United States and Britain which can create central bank crediton their own computer keyboards to keep their economy from shrinking orbecoming insolvent, the German constitution and the Lisbon Treaty prevent thecentral bank from doing this.
Theeffect is to oblige governments to borrow from commercial banks at interest.This gives bankers the ability to create a crisis – threatening to driveeconomies out of the Eurozone if they do not submit to “conditionalities” beingimposed in what quickly is becoming a new class war of finance against labor.
Disabling Europe’s central bank to deprive governments of the power tocreate money
Oneof the three defining characteristics of a nation-state is the power to createmoney. A second characteristic is the power to levy taxes. Both of these powersare being transferred out of the hands of democratically electedrepresentatives to the financial sector, as a result of tying the hands ofgovernment.
Thethird characteristic of a nation-state is the power to declare war. What ishappening today is the equivalent of warfare – but against the power of government! It is above all a financial modeof warfare – and the aims of this financial appropriation are the same as thoseof military conquest: first, the land and subsoil riches on which to chargerents as tribute; second, public infrastructure to extract rent as access fees;and third, any other enterprises or assets in the public domain.
Inthis new financialized warfare, governments are being directed to act asenforcement agents on behalf of the financial conquerors against their owndomestic populations. This is not new, to be sure. We have seen the IMF andWorld Bank impose austerity on Latin American dictatorships, African militarychiefdoms and other client oligarchies from the 1960s through the 1980s.Ireland and Greece, Spain and Portugal are now to be subjected to similar assetstripping as public policy making is shifted into the hands ofsupra-governmental financial agencies acting on behalf of bankers – and therebyfor the top 1% of the population.
Whendebts cannot be paid or rolled over, foreclosure time arrives. For governments,this means privatization selloffs to pay creditors. In addition to being aproperty grab, privatization aims at replacing public sector labor with anon-union work force having fewer pension rights, health care or voice inworking conditions. The old class war is thus back in business – with afinancial twist. By shrinking the economy, debt deflation helps break the powerof labor to resist.
Italso gives creditors control of fiscal policy. In the absence of a pan-EuropeanParliament empowered to set tax rules, fiscal policy passes to the ECB. Acting onbehalf of banks, the ECB seems to favor reversing the 20th century’sdrive for progressive taxation. And as U.S. financial lobbyists have madeclear, the creditor demand is for governments to re-classify public socialobligations as “user fees,” to be financed by wage withholding turned over tobanks to manage (or mismanage, as the case may be). Shifting the tax burden offreal estate and finance onto labor and the “real” economy thus threatens tobecome a fiscal grab coming on top of the privatization grab.
Thisis self-destructive short-termism. The irony is that the PIIGS budget deficitsstem largely from un-taxing property, and a further tax shift will worsenrather than help stabilize government budgets. But bankers are looking only atwhat they can take in the short run. They know that whatever revenue the taxcollector relinquishes from real estate and business is “free” for buyers topledge to the banks as interest. So Greece and other oligarchic economies aretold to “pay their way” by slashing government social spending (but notmilitary spending for the purchase of German and French arms) and shiftingtaxes onto labor and industry, and onto consumers in the form of higher userfees for public services not yet privatized.
In Britain,Prime Minister Cameron claims that scaling back government even more alongThatcherite-Blairite lines will leave more labor and resources available forprivate business to hire. Fiscal cutbacks will indeed throw labor out of work,or at least oblige it to find lower-paid jobs with fewer rights. But cuttingback public spending will shrink the business sector as well, worsening thefiscal and debt problems by pushing economies deeper into recession.
Ifgovernments cut back their spending to reduce the size of their budget deficits– or if they raise taxes on the economy at large, to run a surplus – then thesesurpluses will suck money out of the economy, leaving less to be spent on goodsand services. The result can only be unemployment, further debt defaults andbankruptcies. We may look to Iceland and Latvia as canaries in this financialcoalmine. Their recent experience shows that debt deflation leads toemigration, shortening life spans, lower birth rates, marriages and familyformation – but provides great opportunities for vulture funds to suck wealthupward to the top of the financial pyramid.
Today’seconomic crisis is a matter of policy choice, not necessity. As PresidentObama’s chief of staff Rahm Emanuel quipped: “A crisis is too good anopportunity to let go to waste.” In such cases the most logical explanation isthat some special interest must be benefiting. Depressions increaseunemployment, helping to break the power of unionized as well as non-unionlabor. The United States is seeing a state and local budget squeeze (asbankruptcies begin to be announced), with the first cutbacks coming in thesphere of pension defaults. High finance is being paid – by not paying theworking population for savings and promises made as part of labor contracts andemployee retirement plans. Big fish are eating little fish.
Thisseems to be the financial sector’s idea of good economic planning. But it isworse than a zero-sum plan, in which one party’s gain is another’s loss.Economies as a whole will shrink – and change their shape, polarizing betweencreditors and debtors. Economic democracy will give way to financial oligarchy,reversing the trend of the past few centuries.
IsEurope really ready to take this step? Do its voters recognize that strippingthe government of the public option of money creation will hand the privilegeover to banks as a monopoly? How many observers have traced the almostinevitable result: shifting economic planning and credit allocation to thebanks?
Even ifgovernments provide a “public option,” creating their own money to financetheir budget deficits and supplying the economy with productive credit torebuild infrastructure, a serious problem remains: how to dispose of theexisting debt overhead now acts as a deadweight on the economy. Bankers and thepoliticians they back are refusing to write down debts to reflect the abilityto pay. Lawmakers have not prepared society with a legal procedure for debtwrite-downs – except for New York State’s Fraudulent Conveyance Law, callingfor debts to be annulled if lenders made loans without first assuringthemselves of the debtor’s ability to pay.
Bankers donot want to take responsibility for bad loans. This poses the financial problemof just what policy-makers should do when banks have been so irresponsible inallocating credit. But somebody has to take a loss. Should it be society atlarge, or the bankers?
It is not aproblem that bankers are prepared to solve. They want to turn the problem overto governments – and define the problem as how governments can “make themwhole.” What they call a “solution” to the bad-debt problem is for thegovernment to give them good bonds for bad loans (“cash for trash”) – to bepaid in full by taxpayers. Having engineered an enormous increase in wealth forthemselves, bankers now want to take the money and run – leaving economies debtridden. The revenue that debtors cannot pay will now be spread over the entireeconomy to pay – vastly increasing everyone’s cost of living and doing business.
Whyshould they be “made whole,” at the cost of shrinking the rest of the economy? Thebankers’ answer is that debts are owed to labor’s pension funds, to consumerswith bank deposits, and the whole system will come crashing down if governmentsmiss a bond payment. When pressed, bankers admit that they have taken out riskinsurance – collateralized debt obligations and other risk swaps. But theinsurers are largely U.S. banks, and the American Government is pressuringEurope not to default and thereby hurt the U.S. banking system. So the debttangle has become politicized internationally.
Sofor bankers, the line of least resistance is to foster an illusion that thereis no need for them to accept defaults on the unpayably high debts they haveencouraged.  Creditors always insist thatthe debt overhead can be maintained – if governments simply will reduce otherexpenditures, while raising taxes on individuals and non-financial business.
The reason whythis won’t work is that trying to collect today’s magnitude of debt will injurethe underlying “real” economy, making it even less able to pay its debts. Whatstarted as a financial problem (bad debts) will now be turned into a fiscalproblem (bad taxes). Taxes are a cost of doing business just as paying debtservice is a cost. Both costs must be reflected in product prices. Whentaxpayers are saddled with taxes and debts, they have less revenue free tospend on consumption. So markets shrink, putting further pressure on theprofitability of domestic enterprises. The combination makes any countryfollowing such policy a high-cost producer and hence less competitive in globalmarkets.
Thiskind of financial planning – and its parallel fiscal tax shift – leads towardde-industrialization. Creating ECB or IMF inter-government fiat money leavesthe debts in place, while preserving wealth and economic control in the handsof the financial sector. Banks can receive debt payments on overly mortgagedproperties only if debtors are relieved of some real estate taxes. Debt-strappedindustrial companies can pay their debts only by scaling back pensionobligations, health care and wages to their employees – or tax payments to thegovernment. In practice, “honoring debts” turns out to mean debt deflation and general economic shrinkage.
Thisis the financiers’ business plan. But to leave tax policy and centralizedplanning in the hands of bankers turns out to be the opposite of what the pastfew centuries of free market economics have been all about. The classicalobjective was to minimize the debt overhead, to tax land and natural resourcerents, and to keep monopoly prices in line with actual costs of production(“value”). Bankers have lent increasingly against the same revenues that freemarket economists believed should be the natural tax base.
Sosomething has to give. Will it be the past few centuries of liberal free-marketeconomic philosophy, relinquishing planning the economic surplus to bankers? Orwill society re-assert classical economic philosophy and Progressive Eraprinciples, and re-assert social shaping of financial markets to promotelong-term growth with minimum costs of living and doing business?


At least in the most badly indebtedcountries, European voters are waking up to an oligarchic coup in which taxationand government budgetary planning and control is passing into the hands ofexecutives nominated by the international bankers’ cartel. This result is theopposite of what the past few centuries of free market economics has been allabout.

ECB: Europe’s Last Hope?

The Road to Serfdom

(With apologies to Friedrich Hayek)

The markets are again infree-fall and, once again, a lazy Mediterranean profligate is to blame.  This time, it’s an Italian, rather than aGreek.  No, not Silvio Berlusconi, buthis fellow countryman, Mario Draghi, the new head of the increasingly spinelessEuropean Central Bank.
At least the Alice inWonderland quality of the markets has finally dissipated.  It was extraordinary to observe the euphoricreaction to the formation of the European Financial Stability Forum a few weeksago, along with the “voluntary” 50% haircut on Greek debt (which has turned outto be as ‘voluntary’ as a bank teller opening up a vault and surrendering moneyto someone sticking a gun in his/her face). To anybody with a modicum of understanding of modern money, it wasobvious that the CDO like scam created via the EFSF would never end well andthat the absence of a substantive role for the European Central Bank wouldprove to be its undoing. 

As far as the haircuts went,the façade of voluntarism had to be maintained in order to avoid triggering aseries of credit default swaps written on Greek debt, which again highlightsthe feckless quality of our global regulators being hoisted on their own petard,given their reluctance to eliminate these Frankenstein-like financialinnovations in the aftermath of the 2008 disaster. 
What is required is a “backto the future” approach to banking:  Inthe old days, a banker “hedged” his credit risk by doing (shock!) CREDITANALYSIS.  If the customer was deemed tobe a poor credit risk, no loan was made. 
It goes back to a point wehave made many times:  creditworthinessprecedes credit.  You need policiesdesigned to promote job growth, higher incomes and a corresponding ability toservice debt before you can expect a borrower take on a loan or a banker toextend one.  And, as Minsky used to pointout, in the old days, banking was a fundamentally optimistic activity, becausethe success of the lender was tied up with the success of the borrower; inother words, we didn’t have the spectacle of vampire-like squids bettingagainst the success of their clients via instruments such as credit defaultswaps.
Credit default swapsthemselves are to “hedging” credit exposure what nuclear weapons are to“hedging” national defence requirements. In theory, they both sound like reasonable deterrents to mitigatedisaster, but use them and everything blows up. At least one decent by-product of the eurocrats’ incompetent handling ofthis national solvency disaster has been the likely discrediting of CDSs as ahedging instrument in the future.  Notethat 5 year CDSs on Italian debt have not blown out to new highs today in spiteof bond yields rising over 7%, because the markets are slowly but surely comingto the recognition that they are ineffective hedging instruments – althoughthey have been very useful in terms of lining the pockets of the likes of JPMorgan and Goldman Sachs. 
Say what you willabout Silvio Berlusconi (and there’s LOTS one can say about the man as anyreader of the NY Post can attest).  But hewas right to oppose to a crude political ploy being foisted on him by the ECB,the French and Germans to accept an irrational and economically counterproductiveprogram fiscal austerity program in exchange for “support” from the likes ofthe IMF.   All Berlusconi had to do wascast his eyes to the other side of the Adriatic to see the likely effect ofthat. The markets’ reaction to his resignation was surreal: akin to turkeysvoting for Thanksgiving.   The overriding imperative in Euroland(indeed, in the entire global economy) should be to stimulate economic growth to ensure that there are enoughjobs for all who want them.
Private spending is very flatand so they need to replace it with public spending or GDP will declinefurther. The eurocrats seem incapable of understanding that even if the budgetdeficit rises in the short-run, it will always come down again as GDP growsbecause more people pay taxes and less people warrant government welfaresupport.
As for Italy itself, this isa sordid case of the Europe’s mandarins subverting yet another democracy,through crude economic blackmail. Already one government has been destroyed this way: In the words ofFintan O’Toole of the Irish Times:

Firstly, it was madeexplicit that the most reckless, irresponsible and ultimately impermissiblething a government could do was to seek the consent of its own people todecisions that would shape their lives. And, indeed, even if it had gone ahead,the Greek referendum would have been largely meaningless. As one Greek MP putit, the question would have been: do you want to take your own life or to bekilled? Secondly, there was open and shameless intervention by European leaders(Angela Merkel and Nicolas Sarkozy) in the internal affairs of another state.Sarkozy hailed the “courageous and responsible” stance of the main Greekopposition party – in effect a call for the replacement of the elected Greekgovernment.
The third part of thismoment of clarity was what happened in Ireland: the payment of a billiondollars to unsecured Anglo Irish Bank bondholders. Apart from its obviousobscenity, the most striking aspect of this was that, for the first time, wehad a government performing an action it openly declared to be wrong. MichaelNoonan wasn’t handing over these vast sums of cash from a bankrupt nation tovulture capitalist gamblers because he thought it was a good idea. He was doingit because there was a gun to his head. The threat came from the EuropeanCentral Bank and it was as crude as it was brutal: give the spivs yourtaxpayers’ money or we’ll bring down your banking system.
Of course, this is nothing new for the EU, asany Irishman or Portuguese citizen can attest. Vote the “wrong” way in a national referendum and the result is ignoredby the eurocrats until the silly peasants realize the egregious errors of theirways and re-vote the right way.  If ittakes two, or even three, referenda, so be it. Politically, the interpretation of any aspect of the Treaties relatingto European governance have always been largely left in the hands of unelectedbureaucrats, operating out of institutions which are devoid of any kind ofdemocratic legitimacy.  This, in turn,has led to an increasing sense of political alienation and a corresponding movetoward extremist parties hostile to any kind of political and monetary union inother parts of Europe.  Under politicallycharged circumstances, these extremist parties might become the mainstream.
As for Italy itself, the country runs a primary fiscalsurplus. As George Soros has noted: “Italy is indebted, but it isn’tinsolvent.” Its fiscal deficit to GDP ratio is 60% of the OECD average.  It is less than the euro area average.  Its ratio of non-financial private debt toGDP is very low relative to other OECD economies.  
It is not at all like Greece.  It has avibrant tradeable goods sector.  It sells things the rest of the worldwants. You introduce austerity at this juncture, and you will cause even slowereconomic growth, higher public debt, thereby creating the very type of Greekstyle national insolvency crisis that Europe is ostensibly seeking toavoid.  And then it will move to France,and ultimately to Germany itself.  Nopassenger is safe when the Titanic hits the iceberg.
The entire eurozone is already in severe recession (depression, in fact, is not too strong aword), yet the ECB, the Germans, the French and virtually every single policymaker in the core continue to advocate the economic equivalent of mediaevalblood-letting via ongoing fiscal austerity. And, surprise, surprise, the public deficits continue to grow.
Here’s anotherinteresting thing:  in the 1990s, a number of countries, including Italy,engaged deliberately in transactions which had no economic justification,other than to mask their public debt levels in order to secure entry into theeuro (see an excellent paper on this by Professor Gustavo Piga, “Derivativesand Public Debt Management”, which documents this practice).  Italyactively exploited ambiguity in accounting rules for swap transactions in orderto mislead EU institutions, other EU national governments, and its own publicas to the true size of its budget deficit. 
And Eurostatsigned off on these transactions.  And who worked at the Italian Treasuryat that time?  That’s right:   “SuperMario” Draghi, who was director general of the Italian Treasury from 1991-2001 whenall this was going on, and then joined Goldman Sachs (2002-2005), when theprivatisations came up.  Interesting that he is now the guy who has todeal with the ultimate fall-out.  Karmic justice.
Virtuallyeverybody has lied about their figures (Spain is a notable offender today), solistening to Europe’s high priests of monetary chastity is akin to listening tosomeone coming out of a brothel proclaiming his continued virginity.
Is there a solution?  Ofcourse there is. But the eurozone’s chiefpolicy makers continue to avoid utilizing the one institution – the EuropeanCentral Bank – which has the capacity to create unlimited euros, and thereforeprovides the only credible backstop to markets which continue to query thesolvency of individual nation states within the euro zone.  They are, as Professor Paul de Grauwesuggests, like generals who refuse to go into combat fully armed (European Summits in Ivory Towers”): 
“Thegenerals… announce that they actually hate the whole thing and that they willlimit the shooting as much as possible. Some of the generals are so upset bythe prospect of going to war that they resign from the army. The remaininggenerals then tell the enemy that the shooting will only be temporary, and thatthe army will go home as soon as possible. What is the likely outcome of thiswar? You guessed it. Utter defeat by the enemy.
TheECB has been behaving like the generals. When it announced its programme ofgovernment bond buying it made it known to the financial markets (the enemy)that it thoroughly dislikes it and that it will discontinue it as soon aspossible. Some members of the Governing Council of the ECB resigned in disgustat the prospect of having to buy bad bonds. Like the army, the ECB hasoverwhelming (in fact unlimited) firepower but it made it clear that it is notprepared to use the full strength of its money-creating capacity. What is thelikely outcome of such a programme? You guessed it. Defeat by the financialmarkets.”
The ECB should, as De Grauwesuggests, be using the ecoomic equivalent of the Powell Doctrine: when a nationis engaging in war, every resource and tool should be used to achieve decisiveforce against the enemy, minimizing casualties and ending the conflict quicklyby forcing the weaker force to capitulate.
The ECB is themonopoly supplier of currency.  They can set the price on the rates,(obviously not the supply) so if they set a level (say, Italy at 5%) why shouldthere be a default?  Capitulating to the markets, or entering the battlehalf-heartedly not only ensures more economic collateral damage, buteffectively emboldens the speculators by granting them a free put option onevery nation in the euro zone.  They’llline them up, one by one, starting with Greece and ending with Germany.
The ECB continuesto hide behind legalisms to justify its inaction, ironic, considering theextent to which national accounting fraud has long been tolerated in the eurozone since its inception.  The notionthat it cannot act as lender of last resort is disingenuous:  The ECB does have the legal mandate under its”financial stability” mandate which was provided under the Treaty ofMaastricht. 
True it is fairto say that the whole Treaty of Maastricht is full of ambiguity.  Theinstitutional policy framework within which the euro has been introduced andoperates (Article 11 of Protocol on the Statute of the European System ofCentral Banks (ESCB) and of the European Central Bank) has severalkey elements.
One notable feature of the operation of the ESCB is the apparent absence of the lender of last resort facility, which is an issue raised by the WSJ today, and which Draghi uses to justify his inaction.  But it’s not as clear-cut as suggested: The Protocols under which the ECB is established enables, but does not require, the ECB to act as a lender of last resort.
Proof that theECB exploits these ambiguities when it suits them is evident in its bond buyingprogram.  The ECB articles say it cannotbuy government bonds in the primary market. And this rule was once used as anexcuse not to backstop national government bonds at all.  But this changed in early 2010, when it beganto buy them in the secondary market. 
The ECB also hasa mandate to maintain financial stability.  It is buying government bondsin the secondary market under the financial stability mandate.  And itcould continue to do so, or so one might argue that it could.  True thereis now great disagreement about this within the ECB.  It has been turnedover to the legal department, which itself is in disagreement, which ultimatelysuggests that this is a political judgement, and politics is what is drivingItaly (and soon France) toward the brink.
In fact, giventhe 50% “voluntary” haircut imposed on holders of Greek debt, arguably the ECBis the only entity that can buy these national government bonds today.  As Warren Mosler has noted,it is hard to see how anyone with fiduciary responsibility can  buyItalian debt or any other member nation debt  after EU officials announcedthe plan for  50% haircuts on Greek bonds held by the private sector: 
Yes,all governments have the authority, one way or another, to confiscate aninvestors funds. But they don’t, and work to establish credibility that theywon’t.
Butnow that the EU has actually announced they are going to do it, as a fiduciaryyou’d have to be a darn fool to support investing any client funds in anymember nation debt.
Thelast buyer standing is and was always to be the ECB, which will now be buyingmost all new member nation debt as there is no alternative that includessurvival of the union.
Andwhen this happens there will be a massive relief response, as the solvencyissue will be behind them, with the euro firming as well.
Of course, wewill still have to deal with the reality of a major recession in Europe so longas the faith based cult of Austerians continues to dominate policy making.  Sadly, that’s unlikely to change until peopleare shot on the streets of Madrid or Rome. But at the very least, let’s get this silly national solvency problemaddressed once and for all in the only credible way possible.  Mario Draghi, you have the chance to redeemyourself and your country.  Don’t wastethe opportunity. 

Marshall Auerback’s Talk at FEASTA

Marshall Auerback’s discusses strategies for Ireland in dealing with its debt crisis at FEASTA. Watch below: