Tag Archives: ECB

THERE WILL BE BLOOD

Posted on December 5, 2011 by admin | Comments Off

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:

Expand to the greatest extent possible the European bailout fund (EFSF)
Issue Eurobonds and spread national liabilities across all Eurozone countries
Get the ECB to play an “active role,” i.e. buy Eurozone sovereign debt.
Institute a financial transaction tax
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.

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Tagged ECB, euro crisis, Marshall Auerback, merkel

What the eurozone needs is functional finance

Posted on November 17, 2011 by admin | Comments Off

By Fadhel Kaboub.
(Also featured in the Financial Times)

Sir, The eurozone’s obsession with “sound finance” is the root cause of today’s sovereign debt crisis. Austerity measures are not only incapable of solving the sovereign debt problem, but also a major obstacle to increasing aggregate demand in the eurozone. The Maastricht treaty’s “no bail-out, no exit, no default” clauses essentially amount to a joint economic suicide pact for the eurozone countries.

The eurozone needs a functional finance approach to economic policy, which requires that the European Central Bank, as the monopoly issuer of the currency, acts as a lender of last resort to allow the expansion of aggregate demand through government spending. The ECB’s refusal to use its firepower is what is driving eurozone bond yields to unsustainable levels. The ECB can easily purchase Italian debt to lower yields, but such action would constitute a violation of Article 123 of the European Union treaty. Unfortunately, the likelihood of a swift political solution to amend the EU treaty is highly improbable. Therefore, the most likely and least painful scenario for Italy (Greece, Portugal, Spain etc) is an exit from the eurozone combined with partial default and devaluation of a new national currency.It has been fascinating to watch the entire world turned upside down during the past few weeks over the eurozone’s self-inflicted economic pain – the same pain that so many developing countries have suffered under the Washington consensus austerity measures and sound finance principles.

The takeaway lesson is that financial sovereignty and adequate policy co-ordination between fiscal and monetary authorities are the prerequisites for economic prosperity. In the end, what matters is not the level of the deficit or the national debt, but rather their effects on employment, price stability and economic growth.

Dr. Fadhel Kaboub, Assistant Professor of Economics, Denison University, Granville, OH, US

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Tagged ECB, euro exit, Fadhel Kaboub, functional finance, greece, Italy, maastricht treaty

ECB: Europe’s Last Hope?

Posted on November 14, 2011 by admin | Comments Off

Marshall Auerback on the need for the ECB to perform its duties as lender of last resort.

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Tagged debt crisis, ECB, euro, Italy, Marshall Auerback

The Road to Serfdom

Posted on November 9, 2011 by admin | 2 comments

(With apologies to Friedrich Hayek)

By Marshall Auerback

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.

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Posted in Marshall Auerback, MMT, Uncategorized

Tagged debt crisis, ECB, euro, Hayek, Marshall Auerback, MMT, serfdom

Marshall Auerback on CBC’s Lang and O’Leary Exchange

Posted on October 28, 2011 by admin | Comments Off

“The ECB is the only entity that can create literally trillions of euros till the cows come home..that’s not really issue, the fundamental problem is that you have a currency union without a fiscal structure…”

Watch here (Marshall comes in at about 16:00)

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Europe’s Non-Solution

Posted on October 26, 2011 by admin | Comments Off

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’

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Greece: the ECB’s Daily Floggings will Continue until the Greek Economy Recovers

Posted on October 24, 2011 by admin | Comments Off

By WilliamK. Black

The European “troika” that has been driving Greece into adeepening depression has just completed an analysis documenting the failure ofits policies. The analysis hasleaked. Here are its introductoryparagraphs.

Greece:Debt Sustainability Analysis

October21, 2011

“Since the fourthreview, the situation in Greece has taken a turn for the worse, with the economyincreasingly adjusting through recession and related wage-price channels,rather than through structural reform driven increases in productivity. Theauthorities have also struggled to meet their policy commitments against theseheadwinds. For the purpose of the debt sustainability assessment, a revisedbaseline has been specified, which takes into account the implications of thesedevelopments for future growth and for likely policy outcomes. It has beenextended through 2030 to fully capture long term growth dynamics, and possiblefinancing implications.

The assessment showsthat debt will remain high for the entire forecast horizon. While it woulddecline at a slow rate given heavy official support at low interest rates(through the EFSF [European Financial Stability Facility] asagreed at the July 21 Summit), this trajectory is not robust to a range ofshocks. Making debt sustainable willrequire an ambitious combination of official support and private sectorinvolvement (PSI). Even with much stronger PSI, large official sector support wouldbe needed for an extended period. In this sense, ultimately sustainabilitydepends on the strength of the official sector commitment to Greece.”

The leakedmemo helps explain why the Troika always lets the periphery twist slowly in thewind even though doing so hurts everyone – if this memo is representative theTroika must be choking to death on its jargon, theoclassical economics dogma,and its propaganda. In plain English,the memo concludes:

1. Greece’seconomy is crashing

2. Ourclaim that the “reforms” we were imposing would cause productivity improvementsthat would drive a robust recovery has proven false

3. Ourprediction that the Greek economy would improve and allow Greece to repay itsdebts is inoperative

4. Ournew prediction is that Greek debt will remain dangerously high for the lengthof our prediction (through 2030)

5. If anything nasty happens to the economyduring the next 20 years Greece will be unable to repay its debt

6. Onlylong-term bail outs and requiring Greece’s creditors to take substantial lossescan make it possible for Greece to avoid collapse

Those admissions, while striking, are notthe Troika’s most important admission. Notethat the Troika’s first paragraph contains the remarkable phrase that Greece is“adjusting through recession.” Apparently,Greece is adjusting to a recession “through recession.” One assumes that under this framing Greece“adjusted” to World War II through its troops and civilians dying. What the Troika appears to be trying to sayis that Greek wages are falling as the Greek economy collapses, which causesthe collapse to accelerate. Thememorandum claimed that the Troika’s initial model was based on experience inother nations that were forced to adopt austerity during a severe recession andexperienced remarkable recoveries, but admits that the model has failed inGreece. (The reality is that it failedin the other nations as well, but the Troika is having enough trouble admittingthe truth about Greece.)

The Troika’s new, more pessimisticforecast is that Greece’s recession is mild by the start of 2012 and is over bythe end of 2012. That is an extremelyoptimistic assumption, not a pessimistic one. The odds are strong that the Troika’s austerity program will causeGreece to descend into a severe recession. If it does, the Troika’s plan blows up immediately. But the Troika recognizes that it does notrequire a recession to blow up their projections. “Stresstests to this revised baseline illuminate further the problem with sustainability,revealing that the downward debt trajectory would not be robust to shocks.” If almost anything material goes wrong – overthe next twenty years – the Troika project that the Greek economy would descendinto a debt and deficit death spiral. The odds that nothing relevant to the Greekeconomy and government will go wrong over the next two decades are tiny. The Troika is basing its new plan onassumptions that are so rosy that they could populate a large flower garden.

The Troika assumes that Greece will run avery large “primary surplus” in its budget – and maintain it for decades. The Troika recognizes that this “requiressustained and unwavering commitment to fiscal prudence by the Greek authorities.” There are two problems with thisassumption. It is imprudent to run abudgetary surplus during a collapse of private sector demand that is causing asevere recession. Doing so will make theexisting recession far worse and trying to do so for decades will cause orexacerbate future recessions. The Troikaassumes the opposite: “[S]trong growth willbe very hard to achieve unless Greece’s high debt overhang is decisively tackled.Overall, the scenario emphasizes the crucial importance of frontloadinggrowth-enhancing structural reforms for debt sustainability.” The Troika concedes that it is critical thatGreece promptly achieve substantial growth. The Troika, however, is insisting on austerity – budget surpluses –during a severe recession. That is apro-cyclical policy that makes the recession worse. The Troika is counting on magic –“growth-enhancing structural reforms” to overcome the self-destructive natureof their austerity program and produce a prompt, robust recovery from thereception.

The second problem is that if the Troikabelieves that the Greek government will display a “unwavering commitment” fordecades to actions that are (deservedly) extremely unpopular among theelectorate then it must have been meeting in a an Amsterdam hash house when itwrote this sentence.

Adopting these new myths about Greece’sprompt recovery from recession and maintenance of very large surpluses fordecades allowed the Troika to abandon two prior myths. The memorandum shows that the Troika hasdropped the fantasy that Greece will soon be able to borrow funds from themarkets without any guarantees from the European Central Bank (ECB). The new estimate is that it will take adecade before Greece can borrow and that it will not be able to borrowsubstantial funds “until late [in] the second decade.” Similarly, the Troika finally admits that aGreek default on its existing debt is certain. “Greece’s debt peaks at very high levels and would decline at a very slowrate pointing to the need for further debt relief to ensure sustainability.”

The Troika has not given up one of theircentral myths even though it is one of the most pernicious myths in the last 80years. It is one that Keynes (andreality) disproved long ago. The Troikabelieves that if Greece fell into a deeper recession it would recover more quickly because of the recession. The “logic” is that severe recessions lead tosharp drops in working class wages, which makes the nation far morecompetitive, which expands its exports, which accelerates Greece’s recovery under the Troika’s new model.

“Tomodel this it is assumed that through much deeper recession and deflation thecompetitiveness gap is unwound by 2017, instead of during the next decade. The headwindsfrom the deeper recession are assumed to delay the achievement of fiscal andprivatization policy targets by three years.

Asthe economy rapidly shrinks, debt would reach extremely high levels in theshort run at 208 percent of GDP. If Greece could weather the shock toconfidence this could create, the eventual more rapid recovery of the economywould help bring debt back down towards the revised baseline path….”

This passage “explains” the Troika’s useof the phrase “adjusting through recession.” We can now see what a chilling phrase it is and how little empathy theTroika has for human beings who are suffering. “The competitiveness gap” assumes that the Greek working class isseriously overpaid and that as the recession deepens and causes ever greaterunemployment it will cause Greek wages to fall sharply until it reaches thepoint that the Greeks are competitive with places like Portugal. The Troika propounds the myth that recessionsare self-correcting and that the more severe the recession the “more rapid[the] recovery.”

Greece is already a nation beset bysevere income inequality and unemployment, and the Troika claims thatincreasing the income inequality and unemployment dramatically is one of thekeys to recovery. Slashing working classwages and employment in a Great Recession, however, causes private sectordemand to fall sharply. The underemployedcut their consumption for obvious reasons, but many workers will cutconsumption because they fear that they will lose their jobs. The result of the Troika’s austerity policiesin Greece has not been a recovery, but a deepening depression, as the Troika’smemorandum admits. Greece is notrecovering under the Troika’s self-defeating austerity mandates. The Troika’s policies are analogous todoctors bleeding their patients centuries ago under the delusion that itimproved their health.

In the same quoted passage, the Troikapresents an additional myth – “deflation” causes nations in severe recessionsto recover. Deflation does the opposite,for several reasons. I will explainbriefly only one of these reasons. Whenprices are falling on major goods for which it is often possible to deferpurchases (e.g., buying a new automobile or refrigerator), consumers may defertheir purchases because deflation means that they can buy those goods at alower price in the future. One of thefundamental characteristics of severe recessions is grossly inadequate privatesector demand, so deflation exacerbates recessions by reducing private sectordemand.

The Troika’s memorandum has a revealingaside about what the ECB cares about. The context is the presentation of the necessity of Greece’s creditorsagreeing to large reductions in Greece’s debts.

“DeeperPSI,which is now being contemplated, also has a vital role in establishing thesustainability of Greece’s debt.”

That sentence ends with the followingfootnote.

1“The ECB does not agree with the inclusion of these illustrative scenariosconcerning a deeper PSI in this

report.”

The ECB has no statutory mission toprotect the interests of Greece’s creditors. Its decision to side with the interests of Greece’s creditors(overwhelmingly European banks, particularly German banks) against theinterests of a member nation makes clear why the ECB poses an enormous dangerto Europe. The ECB is dominated bytheoclassical economists who glory in their “independence” from democraticinstitutions but are slavish servants of the systemically dangerousinstitutions (SDIs) – the misnamed “too big to fail” banks.

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Marshall Auerback’s Talk at FEASTA

Posted on October 19, 2011 by admin | Comments Off

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

Marshall Auerback from Feasta on Vimeo.

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Core Europe Sitting Pretty in their PIIGS Drawn Chariot

Posted on October 3, 2011 by admin | 5 comments

By Marshall Auerback and Warren Mosler

The refusal to countenance a Greek default is now said to be dragging the euro zone toward even greater crisis. Implicit in this view, of course, is the idea that the current “bailout” proposals are operationally unsustainable and will lead to a broader contagion which will ultimately afflict the pristine credit ratings of core countries such as Germany and France.

Well, we see a very different view emerging: The “solution” currently on offer – i.e. the talk surrounding the European Financial Stability Fund (EFSF) now includes suggestions of ECB backing. This makes eminent sense. Let’s be honest: the EFSF is a political fig-leaf. If 440 billion euros proves insufficient, as many now contend, the fund would have to be expanded and the money ultimately has to come from the ECB — the only entity that can create new net financial euro denominated assets — which means that Germany need no longer fret about being asked for ongoing lump sums to fund the EFSF in a way that would ultimately damage its triple AAA credit rating.

Despite public protestations to the contrary, it is beginning to look like the elders of the euro zone have begun to embrace the reality that, when push comes to shove, it is the ECB that must write the check, and that it can continue to do so indefinitely.

That means, for example, the ECB can buy sufficient quantities of Greek bonds in the secondary markets to allow Greece to fund itself in the short term markets at reasonable interest rates. And it gets even better than that for the ECB, as the ECB also substantially enhances its profitability by continuing to buy deeply discounted Greek bonds and using Greece’s income stream to build the ECB’s stated capital. As long as it continues to buy Greek debt, Greece remains solvent, and the ECB continues to increase its accrual of profits that flow to capital.

The logical conclusion of all of this is ECB ownership of most of Greece’s debt, with austerity measures imposed by the ECB steering the Greek budget to a primary surplus, along with sufficient taxation to keep the ECB’s capital on the rise, and help fund the ECB’s operating budget as well. Now add to that similar arrangements with Ireland, Portugal, Spain and Italy and it’s Mission Accomplished!

Mission Accomplished? Are we daring to suggest that the Fathers of the euro zone had exactly this in mind when they signed the Treaty of Maastricht?

Or, put it another way: it’s all so obvious, so how could they not have this mind?

So let’s take a quick look at the central bank accounting to see if this seemingly outrageous thesis has merit.

Here is what is actually happening. By design from inception, when the ECB undertakes its bond buying operation, the ECB debt purchases merely shift net financial assets held by the ‘economy’ from Greek government liabilities to ECB liabilities in the form of clearing balances at the ECB. While the Greek government liabilities shift from ‘the economy’ to the ECB. Note: this process does not alter any ‘flows’ or ‘net stocks of euros’ in the real economy.

And so as long as the ECB imposes austerian terms and conditions, their bond buying will not be inflationary. Inflation from this channel comes from spending. However, in this case the ECB support comes only with reduced spending via its imposition of fiscal austerity. And reduced spending means reduced aggregate demand, which therefore means reduced inflation and a stronger currency. All stated objectives of the ECB.

We would stress that this is NOT our PROPOSED solution to the euro zone crisis (see here and here for our proposals), but it is clearly operationally sustainable, it addresses the solvency issues, and puts the PIIGS before the cart, which at least has the appearance of putting them right where the core nations of the euro zone want them to be.

Additionally, the ECB now officially has stated it will provide unlimited euro liquidity to its banks. This, too, is now widely recognized as non-inflationary. Nor is it expansionary, as bank assets remain constrained by regulation including capital adequacy and asset eligibility, which is required for them to receive ECB support in the first place.

To reiterate, it is becoming increasingly clear, crisis by crisis, that with ECB support, the current state of affairs can be operationally sustained.

The problem, then, shifts to political sustainability, which is a horse of a different color. And here is where the Greeks (and the other PIIGS) paradoxically have the whip hand. So long as the Greeks continue to accept the austerity, they wind up being burdened by virtue of their funding of the ECB. The ECB takes in their income payments from the bonds, and the ECB alone ensures that Greece remains solvent. It’s a great deal for the ECB and the core countries, such as Germany, France and the Netherlands, as it costs the core’s national taxpayers nothing. And, as least so far, Greece thinks the ECB is doing them a favor by keeping them out of default. The question remains as to whether the Greeks will continue to suffer from this odd variant of Stockholm (Berlin?) Syndrome.

Perhaps not if some of the more recent proposals make headway. As an example of what might be in store for Greece, consider the “Eureca Project”, publicly mooted in the French press last week. In essence, it aims to reduce “Greek debt from 145% to 88% of GDP in one step” without default (so protecting all northern European banks); reduce ECB exposure to Greek debt (that is, force Greece to pay the ECB for the bonds it has purchased in secondary bond markets) and it claims that it will “kick-start the Greek economy and revive growth and job creation” and promote “structural reform.”

So how is it going to do all of that? Simple: engage in the biggest asset strip in history. The proposal in essence calls for a non-sovereign entity to take all the public assets – hand them over to a holding company funded by the EU which pays Greece who then pay off all it debtors. End of process – except that if it is implemented, the Greeks could well say “Stuff it. Let’s default and take our chances. At least we get to keep our national assets.” That’s the risk that is being run if the ECB and the economic moralists in Germany take this too far. If this proposal were accepted, the eurocrats would in fact have a failed nation state on their hands in 3 months time — in the eurozone, not the Mideast or Africa.

By contrast, the current arrangements seem tame in comparison. They obviate the solvency issue, but even here one wonders how much more can be inflicted on countries such as Greece. We stress that the current arrangements have OPERATIONAL sustainability, not necessarily POLITICAL sustainability. The near universally accepted austerity theme is likely to result in continuously elevated unemployment, and a large output gap in general characterized by a lagging standard of living and high personal stress in general. This creates huge systemic risk insofar as it might well make sense for Greece (and others) ultimately to reject this harsh imposition of austerity. But, so far so good for the core nations, as there appears to be no movement in that directions (except on the streets of Athens, rather than in the Greek Parliament).

By the ECB continuing to fund Greece, and not allowing Greece to default, but instead to continue to service its debt, the whole dynamic has changed from doing Greece a favor by not allowing Athens to default to disciplining Greece by not allowing the country to default. And while that’s what the Germans SEEMINGLY haven’t yet figured out, if one is to judge from the current debate, particularly in Germany itself, at the same time they have approved the latest package and are quickly moving in the direction we are suggesting. Note that Angela Merkel has been most adamant on the particular question of allowing Greece to default or allowing an “orderly restructuring.” It’s also worth noting that when the ECB funds Greece, that funding facilitates Greek purchases of German goods and services, including military, at no cost to the German taxpayer. In fact, Germany gets to run larger trade surpluses, which means by accounting identity it is able to run lower government budget deficits, which allows it to feel virtuous and continue its incessant economic moralizing.

So what’s in it for Germany? That should be obvious by now: Germany gets to export to Greece, and to control/impose austerity on Greece, which keeps the euro strong, interest rates in Germany low, and FUNDS the ECB. All in the name of punishing the Greeks for past sins. It doesn’t get any better than that for the core nations. It’s time for the Germans to stop pushing their luck. Rather, they should embrace the genius of one of the so-called southern profligates, Italy, as they have surely created an operationally sustainable doomsday machine of which Machiavelli himself would be proud. How could this not be the Founding Fathers’ dream come true?