Monthly Archives: October 2011

By Marshall Auerback

Today is supposedly the day where the problems of the euro zone get resolved once and for all. And when have we heard that before? Truth be told, it’s hard to get excited about any of the “solutions” on offer, because they steadfastly refuse to acknowledge that the eurozone’s problem is fundamentally one of flawed financial architecture. The banking “problems” and corresponding “need” for urgent recapitalization, are simply symptoms of that problem. Offering the “cure” of banking recapitalization for a problem which is ultimately one of national solvency (of which the banking crisis is but a symptom) is akin to offering chemotherapy to solve heart disease. Despite the current “thumbs-up” from the markets, the treatment is likely to exacerbate the disease, rather than represent the cure.

Let’s go back to core principles. We agree that the concern about Portugal, Ireland, Italy, Greece and Spain (PIIGS), indeed ALL other Euronations is justified. But using PIIGS countries as analogues to the US is a result of the failure of deficit critics to understand the differences between the monetary arrangements of sovereign and non-sovereign nations. Greece, Italy, France, and yes, Germany, are all USERS of the euro—not an issuer. In that respect, they are more like California, Massachusetts, indeed, any American state or Canadian province, all of which are users of their respective national government’s dollar.

But the eurozone’s chief policy makers continue to ignore this fundamental point and therefore, steadfastly avoid utilizing the one institution – the European Central Bank – which has the capacity to create unlimited euros, and therefore provides the only credible backstop to markets which continue to query the solvency of individual nation states within the euro zone. The ECB is so loath for everybody to agree on a Greek default, on the grounds that they bear “the loss” even though it is a notional accounting loss that has no bearing on their ability to create euros until the cows come home. By contrast, when you get national governments funding the European Financial Stability Fund (EFSF), then it does ultimately threaten the credit ratings of France and Germany once the markets begin to call their bluff on how far they’re prepared to go to support this political fig-leaf called the EFSF. And because NONE of these countries is sovereign in respect to their currency (they USE the euro, but they don’t ISSUE it), it expands the potential insolvency problem, taking Germany down along with the rest.

The market pressures are most acute today in respect of Greece, but the broader concern is that speculators will eventually look toward the bigger PIIGS, such as Italy, and this is where the issue of the European Financial Stability Fund’s structural weaknesses come into play.

Let’s not get bogged down in numbers. The EFSF could have 440 billion euros behind, 1 trillion, 2 trillion, even 10 trillion euros, but it all comes back to the funding sources. The French are right: it makes no sense to implement this program without the backstop of the ECB, which is the only entity that could make any guarantees credible, by virtue of its ability to create unlimited quantities of euros.

Both the leading policy makers within the euro zone and market participants continue to conflate two distinct, but related issues: that of national solvency and insufficient aggregate demand. Policy makers want the ECB to do both, but in fact, the ECB is only required to deal with the solvency issue. When you do that in a credible way, then you get the capital markets re-opened and you give countries a better chance to fund themselves again via the capital markets. It means you do not actually need several trillion dollars, because you have a credible backstop in place – a central bank that can create literally trillions of euros via keyboard strokes and thereby address the markets’ concerns about national solvency. At this point, the bonds of the various nation states become less distressed and the corresponding need for massive banking recapitalization goes away.

Banking recapitalization is being demanded because the eurozone keeps demanding “voluntary” hair cuts” on Greek debt. But letting Greece default will not end Europe’s crisis and will not allow Germany and other core nations to brush themselves off and move merrily on their way. It becomes a question of whether a bailout now is good for Germany and France but not so good for Greece. Because if Greece is allowed to default, then their debt goes away. Authorities in effect agree substantially to lower their debt and reduce their payments.

How does that help the core countries, such as Germany or France? Indeed, getting France and Germany into the sovereign debt guarantee business via the EFSF (which is what happens if the ECB has no role) ultimately contaminates their own national “balance sheets”, thereby causing the markets to query their solvency as well and extending the contagion effects well beyond the PIIGS. We will have a situation akin to Ireland, whereby a country which had fundamentally solid government finances taken down via ill-considered guarantees to its insolvent banking system. Peripheral EMU is to core EMU as Irish banks once were to Ireland. By getting into the guarantee business, Ireland drove down a policy cul de sac from which it is still trying to extricate itself and smeared itself with correlated risk that required it to seek a bailout.

If the ECB continues to fund Greece via its bond purchases and does not allow them to default, then Greece has to continue to make these payments. But the ECB has this weird idea that somehow continuing their bond buying operation allows Greece (and other “fiscal deviants”) to avoid their “fiscal responsibilities” (i.e. continued fiscal austerity). The reality (however misguided), is that the bond buying operations actually provide the ECB with its leverage to force Greece and others to continue their “reforms”. Bond buying by the ECB changes the whole dynamic from doing Greece a favor to disciplining Greece by not allowing them to default and allowing the ECB to collect a significant income stream from the Greeks in the meantime. The minute Greece defaults, this leverage is lost. And then what is to stop the other “problem children” from demanding the same terms?

What is amazing as one listens to the commentary is the number of people who keep defining this as a banking crisis. Worse is their desire to punish the banks, which were told at the euro’s inception that one national bond was as good as another. The system wouldn’t have functioned (or, rather, its flaws would have become manifest sooner) if the national banks had proceeded on the basis that, say, Italian bonds weren’t as good as German bunds. So now the rules are being re-written and the “irresponsible” bankers are to be punished.

Okay, bankers have been irresponsible in a multitude of areas, many of which have already been documented on this blog. But here they are being punished for the wrong things. This is ultimately a national solvency crisis, not a banking crisis, so how does punishing the bankers and their shareholders help here?

Everybody in Europe, save the Germans, appears to understand this right now. Every time something unconventional is urged on the Germans, they scream “Weimar”. One of the indicators of development – intellectual and national and otherwise is to appreciate history and be able to decompose it into components.

Can’t the Germans make that simple division? I was a speaker at an EU forum two weeks with lots of Euro-types flown in. They kept talking about Weimar as if it was yesterday. Rome fell at one time too!

The other alternative is even less pleasant to contemplate, which is that there might be some Machiavellian genius behind the German position: perhaps their goal is to see the rest of Europe economically deflated into the ground, at which point, they will scoop up the pieces on the cheap, bit by bit. They’ll get their empire, albeit 70 years after Hitler expected when he invaded Poland. It’s Anschluss economics writ large. So Germany’s motives are either misguided, or more sinister than is now apparent.

But let’s deal with the core issue first: no solution can be found until the EMU leaders deal with the solvency issue. After that, everything else falls into place. It won’t restart economic growth, but it gets you out of the fiscal straitjacket because once the markets are persuaded that the individual countries are fundamentally solvent, they will lend again at sensible interest rates, which in turn can help to deal with today’s problem of insufficient aggregate demand.. And it means you don’t have to start worrying about massive haircuts on the debt because the bonds are trading at distressed levels precisely because the markets don’t believe these countries have a credible solution for the problem of national solvency.

The revenue sharing proposal which has been proposed by a number of us (see here and here ) is the most operationally efficient manner to involve the ECB, with a minimum of legal disruption. Additionally, it’s not inflationary, as it mere substitutes national bonds with reserves in the banking system and building banking reserves is not inflationary (see here for more)

Questions have been raised both about the ECB’s ultimate solvency and the legal constraints which govern its mandate. To deal with the solvency issue first: has anyone bothered to ask themselves what the concept of solvency means for a central bank that creates its own money? Bill Mitchell has addressed this many times (see here), but if one takes the 30 seconds required to ponder this question, surely we can understand that the concept of solvency is totally and thoroughly irrelevant to a central bank with a sovereign currency (i.e. not convertible on demand into a fixed quantity of other currencies or a commodity).

The ECB and others who resist its involvement in the salvation of the common currency continue to think and act as if it is a central bank operating under a gold standard. That is insane, and certifiably so.

In regard to the legal requirements:

• The ECB does not have a statutory minimum capital requirement.
• It transfers profits to national governments but in times of losses is can only request a capital injection should its capital be depleted.
• The European Council (which is representative of elected governments) is not compelled to accede to this request.
• Hence, the ECB is a perfect balance sheet to warehouse risk since its losses need not become fiscal transfer as it can rebuild its profits via seigniorage over a number of yrs. In that sense, its role is analogous to that of the Swiss National Bank effectively warehoused its Swiss banks’ bad paper during the height of the crisis in 2008.

Of course, the ECB would HATE this and the risk is that its losses would limit its willingness to maintain its bond buying program. But it remains the only game in town. The bond buying is precisely what gives them leverage and, paradoxically, preserves the quality of its balance sheet, since the purchases themselves ensure that the distressed bonds of countries such as Greece do not lose value because the ECB prevents them from defaulting. As we have described before, the ECB effectively uses the income of the Greeks (and others) to rebuild its capital base. The minute the EFSF is introduced, along with the notion of haircuts, the ECB loses its leverage and the credit risk contagion shifts to the core countries of the EU, which WILL threaten their AAA ratings.

It also means this whole issue of banking recapitalisation is a big red herring. In reality, banks don’t really need recapitalisation. What most depositors care about is being able to get their deposit money out of their bank, so whether they are solvent or not is not their primary concern. Arguably, all of the US banks were insolvent in 1982, but the FDIC guarantees worked to stabilise the system.

Bank capital is always available at a price. The ‘market process’ is for net interest margins to widen to the point where earnings attract capital. Except this all assumes credit worthiness isn’t an issue.


The problem with current policy is that it is turning both the public and private sector into a ‘credit event’ which will make it extremely difficult for the borrowers to switch lenders.

In the current environment you have a solvency crisis which is feeding into the banking system because a large proportion of their assets are euro denominated government bonds. Going down the path of “voluntary” hair cuts and forced recapitalization will simply set off a massive debt deflation spiral. We will see bank’s fire selling assets left and right – management will not issue equity at these miserably low price to book values. Which in turn will depress economic activity even further, widen the very public deficits which are so exorcising the Eurozone’s policy making elite, and bring us back to Square One. Already the guns are being turned on Italy, now that Greece is on the threshold of being “solved”.

In the words of Italy’s greatest poet: “Lasciate ogne speranza, voi ch’entrate.”*

*Abandon hope all ye who enter here – Dante, ‘The Inferno’