Since 2009 Greece has been a barometer of the Eurozone’s continued viability. The rake’s progress of the four years to early 2009 had been remarkable. It had run current account deficits (relative to GDP) of 7.6% in 2005, 11.4% in 2006, 14.6% in 2007 and 14.9% in 2008 or, over the four years combined, of about 50% of GDP. The big external creditors included international banks, particularly European banks, which had acquired large holdings of Greek government debt and made loans to Greek banks. The extra debt could be serviced in the long run only if Greece reduced its current account deficit substantially. A devaluation against the currencies of its main trading partners was therefore sensible, in order to motivate the necessary switch of production towards exports. Unfortunately, as a member of the Eurozone single currency area Greece could not devalue. It could leave the Eurozone, but that would shatter the geopolitical dreams of the Eurozone’s architects in Germany and France. For them the single currency area was a permanent structure which foreshadowed ever-increasing economic and political integration in the European Union. As devaluation within the Eurozone was impossible, the focus of the policy drive to improve Greece’s financial position was on the budget deficit. The Eurozone sovereign debt crisis escalated in early 2010. Since then negotiations have been held between international bodies (usually “the troika” of the European Commission, the European Central Bank and the International Monetary Fund) and the Greek authorities, about targets for the reduction of budget deficits and public debt. The Greeks have repeatedly missed the targets. Fiscal austerity and the implosion of the banking system have been associated with a drop in real GDP of almost a quarter in five years. The GDP decline has further pushed up the debt/GDP ratio. This note examines the latest developments. Although the budget deficit numbers have been better in 2012 than in 2011, the macroeconomic trauma is so severe and unrelenting that Greece must leave the single currency area as soon as possible.
This week’s e-mail note is by my colleague, John Petley, and compares Spain with Greece. As the note points out, the situations are very different. No doubt the Spanish banking system has its problems, but there is no certainty that future real estate losses will wipe out its capital. Indeed, if the Eurozone (and hence Eurozone asset prices) were to return to growth as European politicians promise, such losses might be easily manageable. Further, so far Spain’s money supply has not suffered severe contraction, as in the Greek case. The yield spread between German and Spanish government bonds in the one- year area has recently been about 500 basis points. If the banking situation were normal, with readily available inter-bank lines, and 100% certainty about the contractual stability of banks and sovereigns, this would be a fantastic profit opportunity. (Assume internal management capital allocation to the trade of 5% [whatever the Basle rules say], then the return on capital – from an inter-bank borrowing costing 50 basis points with the proceeds invested in Spanish government debt – would be almost 100%.) The reluctance of German banks, and of other banks, to sell one-year bunds and to buy one-year Spanish government paper speaks volumes about the lack of confidence in the permanence of the Eurozone. Even if the Spanish banks were over-capitalized relative to other EU banks, the uncertainty about the Eurozone’s survival would limit their ability to maintain their inter-bank funding. Ditto., as regards sovereign risk. Even if Spain has low government debt (as a % of GDP) relative to other EU nations, the uncertainty about the Eurozone’s survival undermines the Spanish government’s credit-worthiness. That is the Eurozone’s real problem. In this sense the Eurozone is inherently dysfunctional.
A weekly e-mail note with the same title" How worrying are Eurozone money growth trends" as the present one was sent out on 11th May. It pointed out that – because Eurozone banks seem to have drawn nearly all of the 1,000b. euros available to them under the ‘long-term refinancing operations’ – the European Central Bank had only limited ability to lend them more. A figure of 300b. euros therefore seemed – reasonably, plausibly – to be the most that banks could receive in extra central bank credit unless the ECB and the related EU authorities embarked on a new initiative of some sort. As Spain has now stated, without equivocation, that it is shut out of financial markets, an update to the 11th May note is needed. More specifically, Spain cannot issue new government debt except at an unacceptable interest rate (of nearly 7% or even more), while its banks cannot obtain new lines in the inter-bank market or even roll over existing lines. The trouble in the inter-bank market is linked with that in government debt issuance, because Spain’s banks would normally be the principal buyers of new short-dated Spanish government debt. However, the Spanish government has insisted that it will not seek a large-scale international financial bail-out, not least because it has already implemented fiscal austerity measures. Obviously, something has to give. Academics have made proposals that the ECB should let the markets know that it will act as a buyer (‘of last resort’) of Eurozone government bonds, if their yield differential relative to the best sovereign risk (i.e., bunds) exceeds some figure (say, 300 or 400 basis points). But the guardian of the best sovereign risk (i.e., Germany) would then need an enforceable promise of good fiscal behaviour from those with a weaker reputation (i.e., Spain and others). Meanwhile Eurozone M3 fell in April, largely because banks are still under pressure to recapitalize their businesses.
Revelations that the French government is considering an elite Eurozone (i.e., an inner core of Eurozone member states, excluding some of the existing members) have made it essential to analyse the possible results of the Eurozone’s break-up. Drastic contractual revisions would be inevitable, with major effects on the value (in terms of euro) of government bonds and inter- bank deposits. These two assets – usually regarded as being highly nominal- value-certain and hence very safe by banks – would see substantial changes in value. The resulting losses for some banks could destroy all of their capital. If policy-makers were foolish enough in those circumstances to demand that banks “strengthen their balance sheets” (by shedding risk assets and/or assets that had lost much of their value) and “make themselves safer” (by operating with the minimum regulatory capital at all times and raising capital/asset ratios), the Eurozone could suffer an appalling plunge in demand, output and employment. It was these demands – i.e., that banks “strengthen their balance sheets” and add to their capital – that led to the cessation of money growth and the severe downturn of late 2008 and early 2009. The recent rhetoric of some of the key individuals in regulatory officialdom has indeed been depressingly similar to their language three years ago. In this note I argue that instead policy-makers should ensure that the quantity of money continues to grow, and that banks are given time (by means of a long-term, low-cost loan from the state) to rebuild their capital and assets. If a very severe slump threatens, the likelihood has to be that highly expansionary open market operations (similar to the “quantitative easing” adopted in the USA and UK) would be chosen by the European Central Bank and the key Eurozone governments. But it is alarming that until now the emphasis has been on bank recapitalization and the supposed need to make banks “safe”.
In a traditional monetary jurisdiction (i.e., a single government and central bank, and one currency, one legal system and one framework of banking regulation), government debt is free from default risk because – in the extreme – the government can borrow from the central bank. This characteristic of government debt makes it attractive in the conduct of monetary policy, not least because the almost risk-free status of short-dated government debt implies that banks need hold no capital against it. By contrast, in a multi- nation monetary union such as the Eurozone (i.e., a union with several governments, but one central bank and one currency), government debt is not free from default risk because limits have to be imposed on government borrowing from the central bank. Without such limits, a classic ‘free-rider problem’ would emerge. Every government would be tempted to borrow as much as possible from the central bank. Rapid growth of the monetary base and/or the quantity of money would then cause inflation. That inflation would affect all members of the monetary union and not merely the country (or countries) of the government(s) which had borrowed from the central bank. The 1992 Maastricht Treaty tried to pre-empt the problem by i. imposing an outright ban on government borrowing from the central bank and ii. obliging member governments to restrict their debt to 60% of GDP. However, the Maastricht Treaty is dead. First, decisions in May 2010 have made the European Central Bank a source of finance to both Eurozone governments and banking systems, as well as creating a quasi-central bank in the form of the European Financial Stability Fund. (Central bank last-resort lending to banks – a normal central bank function in a traditional monetary jurisdiction – is also needed in a monetary union, but is far more problematic.) Second, government debt is now way above 60% of GDP for the Eurozone as a whole and is rising sharply. Italy, which has a particularly large public debt, is in great trouble.
Bargaining about the coming round of Eurozone debt write-offs is now intense. The situation is clearly unsustainable, in that new debt consists largely of the addition of interest to old debts. If the old debts could not be properly serviced, the new debts certainly cannot be. Debt write-offs/reliefs are inevitable, although their extent and incidence are uncertain. In my view the right overall solution to the crisis has three elements and should apply at least to the PIG countries (i.e., Portugal, Ireland and Greece). First, the PIG countries should be told to leave the Eurozone and to restore their national currencies. They could then devalue and again use the exchange rate to facilitate the resource shift to net exports which is needed for them to service their external debts in a normal way. Secondly, they should all (not just Greece) receive some debt relief, as compensation for the humiliation of being expelled. Finally, much of the cross-border inter-bank exposure of the PIG countries should be ‘nationalised/official-ised’ and become in effect external public debt. The interest rate payable could be well beneath that applicable on inter-bank loans to the PIG banks at present and hence would be more manageable. The main point of this week’s note is to show that the process of ‘official-ising’ bank debt has already gone a long way. Since mid-2008 banks in the PIG countries have not been able to roll over inter-bank borrowings. They have had to repay their inter-bank lines, and borrow from their central banks and/or their governments. Governments have then had to borrow, either from the European Central Bank or the European Financial Stability Fund. When allowance is made for PIG banks’ external assets (which are substantial), their net external liabilities to the international banking system have already fallen sharply.
Another 25 basis point rise in the European Central Bank’s repo rate to 1 ½% has angered politicians in the Eurozone’s periphery. The contrast between business conditions in the core countries (particularly Germany) and the periphery has become extreme. Greece, Ireland and Portugal are likely to suffer further falls in output in 2011, giving them a period of macroeconomic austerity longer and harsher than at any time since the 1930s. Yet the central bank responsible for the management of their currency is putting interest rates up, not down. In the following note I discuss statements in the ECB’s June Monthly Bulletin, which defend the stagnation or semi-stagnation in the M3 money measure since late 2008. I argue that the ECB’s description of this stagnation/semi- stagnation as a benign ‘unwinding of accumulated liquidity’ is disingenuous in the extreme. On the contrary, the crash in money growth in late 2008 was sudden and unforeseen. If its deflationary macroeconomic results had not been countered by a collapse in short-term interest rates to virtually zero, the Eurozone would have suffered a recession even worse than that which was actually recorded. Further, the ECB’s ‘exit from non-standard measures’ in 2010 is largely to blame for the severity of the core/periphery imbalance at present. The worry for the future is that the ECB is unconcerned, first, about the slowness of money growth for the Eurozone as a whole and, secondly, about the sharp declines in the quantity of money and associated macroeconomic trauma in the smaller peripheral economies (especially, Greece, Ireland and Portugal). If the central bank in a multi-nation monetary union gears monetary policy to the needs of only one country in that union (i.e., Germany), it will lose popular support and legitimacy in the remaining countries.
Financial crises in the Eurozone periphery are being accompanied by regulatory demands that banks have more capital and shrink their assets, along with reinforced fiscal stringency. So Eurozone M3 – which saw a resumption of growth in summer and autumn 2010 – has stagnated again in the last few months. (M3 was 9,302b. euros in January 2010 and 9,522b. euros in August 2010, implying an annualised growth rate in the seven months of 4.1%. In February 2011 it was 9,543b. euros, barely higher than six months earlier. Last week’s e-mail showed how Ireland’s money supply crashed in 2010, even while banks in other Eurozone countries were expanding their balance sheets. The official pressures on banks in the peripheral countries [i.e., the ‘PIGS’, Portugal, Ireland, Greece and Spain] to raise capital and sell of loan portfolios are clearly a major factor in the latest money slowdown. Because of the recent oil and commodity price surge, real money balances have been falling since autumn 2010. This fall has been most pronounced in the peripheral countries, and is negative for demand and output in their economies this year.) But demand pointers for the Eurozone as a whole, such as leading indicator indices, are satisfactory, even good. The messages have to be that the divergence in macro conditions between the core and periphery will widen in the rest of 2011, putting further strain on the Eurozone’s integrity, and ii. although German export strength may continue, the Eurozone economy will face a monetary headwind in spring 2011. A weakening in business activity would have been likely even before the ECB’s rate rise. The risk of a pause in the Eurozone’s recovery has been increased by the fall in the dollar against the euro, which has advanced since early January from roughly $1.30 to almost $1.45. The euro’s advance, of about 10% or so, seems difficult to justify by the change in interest rate differentials.
In its early years the European Central Bank asserted – loudly and strongly – that it would follow a “stability-oriented” monetary policy. That phrase had been associated for over 30 years with the issuer of the deutschemark and the guardian of its value, the German Bundesbank. In particular, the ECB said it would adhere – like the Bundesbank – to a two-pillar approach to monetary policy-making. The first pillar was the analysis and forecasting of national income determination, the labour market and so on found in all central banks; the second pillar was more distinctive, with its centrepiece being “monetary analysis” to support a desired rate of money growth. The favoured money aggregate – like the Bundesbank‟s – was generally the broad money measure, M3. Much less is heard nowadays about the second pillar. In fact, the position of monetary analysis – let alone M3 targeting – in ECB policy-making has become unclear. In late 2008 and early 2009 the growth of Eurozone M3 collapsed, making a mockery of official claims that the ECB was pursuing a stability- oriented framework. However, the ECB‟s latest Monthly Bulletin includes an article on „Enhancing monetary analysis‟, which is not signed by its authors and so must be intended as a statement from the ECB itself. This weekly e- mail discusses the article in the context of recent Eurozone monetary developments. The main point is simple, that the ECB has participated in the international drive to make banks safe by means of a more restrictive set of Basle rules. It is engaged – like other central banks – in deterring the creation of money by the extension of bank credit to the private sector. In traditional monetary jurisdictions, like the USA or the UK, the state can replace the private sector and create new money balances by such methods as “quantitative easing”. But the article in the ECB‟s November Monthly Bulletin says nothing whatever about QE or indeed about the importance of maintaining a positive rate of money growth to prevent deflation.
Even its most enthusiastic supporters cannot deny that the Eurozone is in trouble. But what will be the key pressure points for a possible break-up? Bitter exchanges of words between politicians in different European countries suggest that hostility to fiscal retrenchment in high-deficit Club Med nations may trigger the final rupture. But another problem needs to be flagged up, that banking systems in the PIIGS group (i.e., Portugal, Ireland, Italy, Greece and Spain) may have so much difficulty funding their assets that they have to borrow on a large and eventually unsustainable scale from the European Central Bank. The decision to end an over-indebted nation’s membership of the Eurozone may be taken not by the government of the nation concerned, but by ECB officials (probably in wider consultations) who say that the ECB cannot increase its exposure to the over-indebted nation further. In this week’s note I have brought together the results of a survey of different Eurozone central bank websites, in order to identify the nations and banking systems most at risk. The results are a mix of the expected and unexpected. As expected, the Irish and Greek banking systems have borrowings from the ECB which are disproportionately large relative to their nations’ GDPs. But – unexpectedly – Italy’s banks have far lower borrowings from the ECB than would have been justified by its output weight in the Eurozone, while both the Spanish and Portuguese banking systems have borrowed only moderately from the central bank. In the case of Ireland the banking system’s borrowings from the ECB at the end of 2009 were 40% - 50% of GDP. No one knows what the precise limit is, but – ultimately – some limit must apply. If the ECB were 100% confident of being repaid, large, long-term loans to solvent banks ought to be maintained. But can the ECB be 100% confident about repayment? I will be reporting regularly on these numbers in coming months, since they will be one of the best indicators of strain in the European single currency area.