There Will Be Blood

by Marshall Auerback, New Economic Perspectives

Editor’s Note: This was written December 5 before the latest Eurozone summit. Readers will find not much has changed as a result of the new agreement reached at that meeting.

Another week to go before the euro blows up, or so we’re told again for the thousandth time. More likely is that the ECB does barely enough to keep the show on the road, fiscal austerity continues and riots intensify on the streets of Madrid, Athens, Rome and Paris. Like the film, “there will be blood” before there is any likely change toward a sensible. growth oriented policy in the euro zone.

Given the travails of the euro zone, why has the euro remained relatively robust? Surely, a currency that is supposedly within weeks of vanishing should be trading closer to parity with the dollar? Yet one continues to be struck by the divergence of opinion and actual market action. For all the talk about the euro possibly vaporizing by Christmas, it is striking that it remains stubbornly stable 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 were rampant).

By the same token, we have a paradox on the other side as well: every time it appears as if a solution to the problems posed by the euro look to be close to resolution, the euro strengthens. Perhaps this isn’t so odd, except that the solution that virtually everybody agrees will work – namely, a sustained and more 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 always told that “QE” represents “printing money”, which should cause a currency to go down? Isn’t that what all of the opponents of the Fed’s program last year were asserting?

Of course, in the case of the European Monetary Union, ECB President Mario Draghi insists that such bond buying will not take place in the absence of proper “sequencing”, by which he means agreed fiscal austerity 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) can only come through fiscal policy. And certainly, in the teeth of a severe recession, such cuts as those proposed by the client state governments of Italy and Greece (along with a renewed assault by President Sarkozy on the French welfare state) will almost certainly exacerbate the profoundly deflationary pressures now operating in the eurozone. Ultimately, this will surely have the result of creating substantially more social instability and bloodshed, but it might have little impact on the euro itself.

So what is actually happening to the euro? Let’s take a step back from the panic talk. The most recent data from the COMEX suggests that speculators are heavily short euro and yet the currency has fallen less than 10% from its recent highs. The question one might legitimately pose is: at what point does the current fiscal austerity produce higher deficits, which in theory should produce a weaker euro (as the euros become “easier to get”)?

I have been wrestling with this issue, and keep getting back to a strong currency, even with increased fiscal deficits. Why?

For one, the ECB’s bond purchases in the secondary market are operationally sustainable and non-inflationary. When the ECB undertakes its bond buying operation, its debt purchases merely shift net financial assets held by the ‘economy’ from national government liabilities to ECB liabilities in the form of clearing balances at the ECB. At the same time, so-called PIIGS 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.

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 comes from spending. However, in this case the ECB support comes only with reduced spending via its imposition of fiscal austerity. Mr. Draghi has now made this explicit and it is almost certainly the German quid pro quo for tacitly supporting a proposed expansion of the Secondary Market Program (SMP). And reduced spending means reduced aggregate demand, which therefore means reduced inflation and a stronger currency. We also know from an authority no less than the BIS (ironically, the same initials as “blood in streets”) that banks cannot lend out reserves (see here – ), so increasing reserves in the banking system is NOT inflationary per se, as the Weimar hyperinflation hyperventilators continue to warn us.

Now consider the trade channel: despite today’s rapidly weakening economy (Europe is almost certainly in recession today), we are not seeing much deterioration in the euro zone’s current account deficit. The Eurozone, in fact, seems to be a pretty self-contained, and somewhat mercantilist economy, which displays far less proclivity 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 in fact go up in this kind of environment.

So that’s euro friendly.

As far as what happens if the ECB were to expand significantly its bond buying program in the secondary market, the notion that the euro would fall is akin to the reasoning that the dollar would collapse if it engaged 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 euro denominated government bonds has resulted in any kind of monetary inflation, as nothing but deflationary pressures continue to mount in that ongoing debt implosion. The reason there is no inflation from the ECB bond buying is because all it does is shift investor holdings from national govt. debt to ECB balances, which changes nothing in the real economy.

But the question which persistently arises when one advocates a larger institutional role for the ECB is whether the ECB’s balance sheet would be impaired, and the MMT contention has long been NO, because if the ECB bought the bonds then, by definition, the “profligates” do not default. In fact, as the monopoly provider of the euro, the ECB could easily set the rate at which it buys the bonds (say, 4% for Italy) and eventually it would replenish its capital via the profits it would receive from buying the distressed debt (not that the ECB requires capital in an operational sense; as usual with the euro zone, this is a political issue). At some point, Professor Paul de Grauwe is right: convinced that the ECB was serious about resolving the solvency issue, the markets would begin to buy the bonds again and effectively do the ECB’s heavy lifting for them. The bonds would 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, not operational “sustainability”.

So the grand irony of the day remains this: while there is nothing the ECB can do to cause monetary inflation, even if it wanted to, the ECB, fearing inflation, holds back on the bond buying that would eliminate the national govt. solvency risk but not halt the deflationary monetary forces currently in place.

Okay, so who takes the losses? Well, presuming the bonds don’t mature at par, no question that a private bank which sells a bond at today’s distressed levels might well take a loss and if the losses are big enough, then banks in this position might well need a recapitalization program.  And in this scenario Germany too could take a hit, as does every other national government as they use national fiscal resources to recapitalize. And the hit will get bigger the longer the Germans continue to push this crisis to the brink.

But that is a separate issue from the question of whether the bond buying program per se will pose a threat to the ECB’s balance sheet. It will not: a big income transfer from the private bond holders who sell to the ECB, which can build up its capital base via the profits it makes on purchasing these distressed bonds. So again, the notion of an ECB being capital constrained is insane.

By contrast, the status quo is a loser for everybody, including Germany. A broader ECB role as lender of last resort of the kind the Germans are still publicly resisting, along with their unhelpful talk of haircuts and greater private sector losses, actually do MUCH MORE to wreck Germany’s credit position than the policy measures which virtually everybody else in Europe is recommending. Why would any private bondholder with a modicum of fiduciary responsibility buy a European bond, knowing that the rules of the game have changed and that the private buyer could find himself/herself with losses being unilaterally imposed? The good news is that there finally appears to be some recognition of the dangers of this approach. Per the WallStreet Journal:

“Ms. Merkel signalled on Friday that she is having second thoughts about the wisdom of emphasizing bondholder losses: ‘We have a draft for the ESM, which must be changed in the light of developments’ in financial markets since the Greek-restructuring decision in July, she said after meeting Austria’s chancellor in Berlin. Austrian Finance Minister Maria Fekter, speaking at a conference in Hamburg on Friday, was more direct. ‘Trust in government treasuries was so thoroughly destroyed by involving private sector investors in the debt relief that you have to wonder why anyone still buys government bonds at all,’ Ms. Fekter said.”

There are other issues which are making Germany’s position increasingly untenable, notably on the political front, in particular the mounting strains between France and Germany. Wolf Richter notes that virtually every leading candidate in the French Presidential campaign envisages a much more aggressive role for the ECB going forward. If Chancellor Merkel thinks she’s going to have a tough time now, wait until she is potentially dealing with Francois Hollande, the French Socialist Presidential candidate, who is now ahead in the all of the polls, and who advocates a five-point plan which is anathema to Germany’s governing coalition:

1. Expand to the greatest extent possible the European bailout fund (EFSF)
2. Issue Eurobonds and spread national liabilities across all Eurozone countries
3. Get the ECB to play an “active role,” i.e. buy Eurozone sovereign debt.
4. Institute a financial transaction tax
5. Launch growth initiatives instead of austerity measures.

As Richter notes, issues 1, 2, 3, and 5 are all non-starters amongst Berlin’s policy making elites. Even more extreme are the views of Socialist candidate, Arnaud Montebourg, who has openly spoken of “the annexation of the French right by the Prussian right.”

On the right, things are not much better. French President Nicolas Sarkozy risks being outflanked by National Front leader, Marine Le Pen (whose father is Jean Marie Le Pen), who is adopting an explicitly anti-euro candidacy, which is gaining traction as France’s new austerity measures continue to bite into economic growth. In his futile attempts to maintain France’s AAA credit rating via increased fiscal austerity, Sarko risks being hoisted by his own petard, as the likely impact of such measures will 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 to negotiate a peace treaty with Al Qaeda.

True, Germany might well decide that enough is enough, that the ECB’s actions represent “printing money” and may therefore initiate a process of leaving the euro zone. But let us be clear about the consequences: Were it to adopt this approach, Germany would likely suffer from a huge trade shock, particularly as its aversion to “fiscal profligacy” would doom it to much higher levels of unemployment (unless the government all of a sudden experienced a Damascene conversion to Keynesianism – about as likely as a Klansman attending a Presidential rally for Barack Obama) or reverting to its former policy of dollar buying. It might also affect the living standards of the average German as well because Germany’s large manufacturers originally bought into the currency union because they felt it would prevent the likes of chronic currency devaluers, such as the Italians, to use this expedient to achieve a higher share of world trade at Germany’s expense.

Were they confronted with the loss of market share, German multinationals might simply move manufacturing facilities to the new, low cost regions of Europe to preserve market share and cost advantage or, at the very least, use the threat of moving to extort cuts in wages and benefits to German works as a quid pro quo for remaining at home. Perhaps there would be blood in the streets of Berlin at that point as well.

In fact, it is doubly ironic that Germany chastises its neighbors for their “profligacy” but relies on their “living beyond their means” to produce a trade surplus that allows its government to run smaller budget deficits. Germany is, in fact, structurally reliant on dis-saving abroad to grow at all. Current account deficits in other parts of the euro zone are required for German growth. It is the height of hypocrisy for Germans to berate the southern states for over-spending when that spending is the only thing that has allowed Germany’s economy to grow. It is also mindless for Germans to be advocating harsh austerity for the south states and hacking into their spending potential and not to think that it won’t reverberate back onto Germany.

Now, of course, German Chancellor Angela Merkel may not consciously know all of these things. In fact, she termed accusations of Germany seeking to dominate Europe “bizarre”. But it is clear to any objective observer that the political quid pro quo for greater ECB involvement in dealing with Europe’s national solvency crisis is German control over the overall 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 is playing a German game of chicken: he is embracing exactly the strategy that Angela 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 cohesive euro zone without the troublesome profligates, the policy elites in fact recognize that a “United States of Germany” under the guise of a United States of Europe, actually suits their aspirations to dominate Europe politically and economically. Which is why the outlines of a deal along the lines of increased ECB involved as a quid pro quo for greater German control of fiscal policy across the euro zone, is emerging. It’s the equivalent of the golden rule: “He who has the gold, rules.” It is high stakes poker, and one which will ultimately lead to far more bloodshed, as my friend, Warren Mosler, aptly noted in a recent blog post:

There is no plan B. Just keep raising taxes and cutting spending even as those actions work to cause deficits to go higher rather than lower.

So while the solvency and funding issue is likely to be resolved, the relief rally won’t last long as the funding will continue to be conditional to ongoing austerity and negative growth.

And the 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 fund and at the same time mandate the higher deficits needed for a recovery, In which case the only thing that will end the austerity is blood on the streets in sufficient quantity to trigger chaos and a change in governance.” (our emphasis)

And by the way, the notion suggested by some that this horrible dynamic could be arrested by the Fed acting as a kind of global central banker of last resort is asinine. As Bill Mitchell noted recently:

As of today, the 1 Euro = 1.3294 U.S. dollars. So just purchasing the PIIGS debt to fund their 2010 deficits would have required the US Federal Reserve sell around 347,024 million USD which is about 5.8 per cent of the US GDP over the last four quarters. That is a huge injection of US dollars into the world foreign exchange markets.

The volume of spending that would be required are even larger than the estimates provided here. That is, because to really solve the Euro crisis the deficits in (probably) all the EMU nations have to rise substantially.

What do you think would happen to the US dollar currency value? The answer is that it would drop very significantly. The word collapse might be more appropriate than drop…At this point in the crisis, there is nothing to be gained by a massive US dollar depreciation and the inflationary impulses such a large depreciation would probably impart.

Blaming the Fed for a failure to backstop the eurozone’s bonds is akin to blaming a bystander for not standing in front of a bullet when he witnesses somebody taking out a gun, and shooting another person. The triggerman bears ultimate responsibility. By the same token, the euro crisis is a crisis which has its roots in the eurozone’s flawed financial architecture (no less an authority than Jacques Delors has recently admitted this ), and can only be solved by the Europeans, specifically, the ECB, which is the only institution in the EMU that can spend without recourse to prior funding, due to the flawed design of the monetary system that was forced upon the member states at the inception of the union.

But Mario Draghi accepts the German political quid pro quo: in order to act, he will insist on greater fiscal austerity as a necessary condition, which will perversely have impact of deflating these economies into the ground further and engender HIGHER public deficits. Obviously this is one reason the Germans felt so comfortable in naming an Italian to the ECB. Trojan horses apparently don’t just come in Greek forms these days. A Europe, where countries such as Italy and Greece become client states of Germany provides a much more effective outcome for Germany than, say, trying to do the same thing via another destructive World War.

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About the Author

Marshall Auerback has over 28 years of experience in investment management. Since 2003, he has worked as a global portfolio strategist for RAB Capital PLC, a UK-based fund management firm, and as a consulting economist for PIMCO.