Why the ECB’s Latest Plan Will Fail
The latest plan out of Europe has everyone breathing a huge sigh of relief. It almost looks like the crisis is over. But it’s not. This was really nothing more than a very hard kick of the can. The reasoning is simple and I’ll go over it again.
First of all, Europe has a crisis because they instituted a single currency without any internal rebalancing mechanism. That is, there is no floating exchange rate between nations with a trade deficit or trade surplus because they all use the same currency. And there is no central treasury to rebalance economic disparities via taxes and spending. And lastly, there is no central bank and treasury relationship that eliminates the solvency risk at the sovereign level. So, for instance, what we have in the USA is a similar system with no floating exchange rate. But the Federal government takes billions from all of the states and redistributes the funds. The states have balanced budget amendments, but the fund flow from Uncle Sam helps reduce and almost entirely eliminate the potential for a large scale bankruptcy at the state level. It’s also highly unlikely that the Federal government would even allow a state insolvency, but that’s a slightly different matter. So the big difference between Europe and the USA is that the USA is a UNITED STATES. Europe is an disjointed mix of different states. Crisis was inevitable.
So what has been done? The latest plan by the ECB is very similar to past plans. Bill Mitchell had a very excellent explanation:
“What is the ECB going to do?
The ECB will purchase short-maturity bonds (1 to 3 years) in the secondary market. Essentially, the primary bond dealer will know that they can easily off load any bond purchases in the secondary market to the ECB.
The ECB will massage their action – to make it look as though they are only undertaking the purchases to help the operations of the financial system rather than fund government deficits – by claiming that because the government debt markets are part of the overall financial market transactions their purchases will improve the monetary transmission mechanism which will, in their eyes, help support the private demand for credit.
The logic of the action is that by buying large volumes of short-term maturity bonds, the price rises and this drives down the yields. Bond traders then are forced to purchase longer maturity government bonds if they want higher yields which then drives prices up and yields down.
Lower interest rates then are considered conducive to rising private demand for credit which, in turn, will help stimulate private investment spending and kick-start growth.”
But the kicker:
“Their statement has some other significant points.
First, they are only going to purchase government bonds if the nation is already undergoing a fiscal austerity program forced on it by the Troika. The ECB say:
A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme … The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.
By which you understand that the ECB decision is in denial of the real problem – a lack of growth. They are saying that they will keep a member state alive so that it can die slowly. They know that if such a nation is forced to deal with private bond markets to gain funds to cover their budget deficit – that the Eurozone will collapse.”
This plan still fails to address the primary issue which is the lack of a rebalancing mechanism. The austerity is the antithesis of rebalancing. So while the solvency issue is being addressed by bringing private bidders back to bond markets it is almost guaranteed to be offset by the fact that these countries still aren’t going to experience growth that makes their debts sustainable. So this crisis will flare up again at some point if a permanent fix isn’t implemented. This latest “fix” buys them some time, but is really nothing more than a kick of the can.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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36 Comments
Europe needs growth. Not austerity. I thought we all knew austerity didn’t work?
Agreed. What I can’t seem to wrap my head around is why the EURO has been rallying so strongly against the dollar? I know it’s a short term move but it seems that what they are going to institute would begin the process of weakening their currency.
I’m not sure it’d weaken the currency. The bond purchases will be sterilized (i.e., any new money the ECB puts into the system would be offset by them withdrawing it somewhere else).
The ECB can’t/won’t do large, unsterilized bond purchases like the Fed did.. and even that is somewhat ineffective at actually creating inflation.
Read this about “sterilization”. And no, it does not involve Chlorox, UV light or gamma rays.
http://www.zerohedge.com/news/guest-post-how-draghi-opened-door-hyperinflation-and-denied-fed-exit-strategy
Do you think you know something Mario Dragi doesn’t know. The problem is worker productivity. These weak country’s need more belt tightening. They need open their markets and have less government interference. If they aren’t reformed they’ll never be abe to compete. Dragi’s giving them time to achieve reform. Like a unified banking system etc.
The mindset of Europeans is very different to that of Americans. There is very little demand to ‘get government out of the way’ or ‘let the free market decide’.
In a lot of European countries, regulation is seen as necessary and in some cases a positive thing.
The state provides many more services that are deemed essential. As someone who lives in the UK, I am utterly bewildered by the attitudes I read from US citizens about state-provided services.
A political decision to reduce workers rights would be electoral suicide as would a decision to open markets. State backed companies from France and Germany have moved into the UK, where they welcome competition, but fiercely defend their monopolies at home.
Ultimately, it will be a creep towards Federalism or a break-up of the Union. The problem is that both of those options are not welcomed by the electorates. So, the most sensible short-term answer for the politicians is to implement a solution that hides the problem for a bit and not face the tough choices. That is what they have been doing and will continue to do, unless some large event forces them to confront the fundamental dilemma at the heart of the Euro project. Unfortunately, this is probably the worst thing to do economically.
This time around it was more than can kicking, to use the football lingo, it was more akin to the 98 yard punt by Steve O’Neal from the Jets versus the Broncos in 1969.
Well guess what, the Jets still lost that game…
Best,
Martin
http://www.youtube.com/watch?v=htKoikjH0L8
Yes it is can kicking but a really strong kick. It will allow the politician the time for real integration. It’s not necessary for the EU to go all in in the next 18 months or so but a bank union and some strong agreement in term of fiscal policy and some large scale european pro growth project financed by BEI will kick the can for another 3 to 5 years again in order to finalize the EU system as a real federation. So for me there will be european people though the next elections (Italy and Germany next year) that will decide the fate of the EU and not the markets or Draghi. This is the logical conclusion of a project that was political from the beginning and not economical, something that anglo-saxons still do not undersant: or the EU will be a political success or it will go back to single nations and currencies. Play your bet but do not underestimate the players.
Cullen,
I don’t think there was any pretense on part of Mario Draghi that he has solved the problem.
He has created an environment so that politicians can peacefully resolve the crisis instead of being forced into a summit by the financial markets panicking.
Growth can be of different types. One dangerous type of growth is the growth of domestic demand faster than the growth of domestic output (resulting in imbalances worsening) and fiscal policy cannot – by itself – cannot take care of this. Hence the ECB wants to impose conditions. It will be a big creditor if situation demands and it cannot take such huge credit risks. Also, allowing nations to design their own fiscal policy will result in their rejection of the German plan of all EA nations surrendering their powers to the EU (necessary to achieve a political union).
Hi Ramanan,
I didn’t mean to imply that Draghi thinks he fixed the Euro. But I am seeing a lot of people saying that this is what he’s achieved. I think Draghi knows he’s bought time. But that’s about all. As you noted, the problems are more complex than just generating demand for sov debt.
Cullen
Cullen,
Might be helpful to understand clearly your definition of “fail” as you see it.
And/or how failure would be evident.
Fail, as in, doesn’t resolve the actual underlying problem. It might keep things from spiraling out of control in the near-term, but by my estimaation, this is like putting a man on life support rather than fixing the problem that ails him….What are your thoughts?
I don’t define it in terms of failure. I see it as one step in a process where there’s just a long road of hard work and no magic bullet. They can’t reconstruct the history of the thing.
Hey, you’re much more precise and calculated than I am. My language is probably a bit dramatic….
Not really trying to pin anybody down on the definition of “failure”. But I think its interesting that different people may have different definitions and/or criteria for failure or success, and over different time horizons and visions for the ultimate solution of the problem. I think in the circumstances that Draghi’s approach as an incremental step may even be “pragmatic” (
). It doesn’t solve the problem, but it may not be intended to solve the problem all at once, and so I wouldn’t rush to classify it as a failure, myself.
BTW, I think Bill Mitchell got the following wrong out of the gate (but others have as well, IMO):
The fact that “No ex ante quantitative limits are set on the size of Outright Monetary Transactions” does NOT mean an “ECB decision to purchase unlimited volumes of government debt” (Bill in quotes there).
That’s quite absurd just to read it when you think about it. There’s obviously no way in heaven that the ECB will purchase “unlimited” volumes of anything.
This is clever wording on the ECB’s part. It’s a statement of not publically declaring a cap on purchases, while executing actual strategy at their own discretion. Obviously, the ECB is going to ration its quantitative strategy and pick its spots as it thinks appropriate. It hasn’t committed to anything; it has complete flexibility.
JKH,
You love to find “errors” in MMT but here you are just trying too hard. Of course the ECB won’t buy unlimited amount of anything because the amount of everything on Earth is limited, not only of bonds. It just means obviously that they target the price and not the quantity, as they should.
Where did they say they were setting and/or announcing specific price targets?
The reason it won’t work is that the debtload will continue to increase. It’s kicking the can down the road. As soon as a significant chunk of the debt is written off, then an economy can recover. Otherwise it’s kicking the proverbial can down the road, hoping the road won’t end too soon.
If I keep giving you enough time to pay and your circumstances gradually improve because you are pulled along by the global economy then the debt is eventually repaid ,but by then it simply won’t buy very much. This is actually the story of GFC post global economics abd because the scale of debt was as high as it was there was never going to be an alternative to ‘debt forgiveness’ even when the latter just means debt maturity will stretch and stretch.
Will the plan bring private bidders back into the bond markets? Or will the ECB be forced to buy up most of the Spanish and Italian short term debt during the next few years? And what happens to the ECB if the Spanish or Italians then decide to leave the ECB? Where will it get the money to repay the short term loans that it used to finance the debt purchases.
It would really be to Spain’s advantage to leave the euro. If the Spanish public ever realizes this, the ECB could be left holding the bag.
Ben,
That’s the primary goal. Bring pvt bidders back to the market and settle the solvency concerns down. Of course, the worry is that things will just get gradually worse as the economies fail to recover and the buying on the primary markets slowly dries up as solvency becomes a concern again as debts are viewed as being unsustainable or political divisiveness leads to the conclusion that this isn’t working….
And the reaction of the people and unions to austerity, loss of jobs and with a political response. In Greece and maybe Spain it could lead to leaving the Euro. France is just entering this scenario of austerity, and their workers traditional responses are well known.
A majority vote to leave the Euro hasn’t happened yet. Even with all the stress Greece is under, the exit forces couldn’t muster even 1/4 of the vote. I think the ECB and TPTB are overly complacent in this. They are assuming that a vote to exit won’t actually happen anywhere, or won’t be implemented even if it does happen. It is very much like assuming that nuclear deterrence will always work just because it worked with the USSR in the cold war. Time honored formulas work until they suddenly don’t work anymore.
Leaving the Euro, for any country, would only make sense if it could be done in an orderly way. However, that is extremely unlikely.
The rumours of a possible exit have already lead to capital flight of deposits from Greece and Spain, which makes the banks weaker and the problems worse.
If people widely believed that a country would leave the Euro, why would they leave their money in a situation where it would become denominated in a currency that was designed to lose value?
There would be bank runs as people rushed to hold all of their savings in Euro notes and the newly introduced currency would have little support from the people. There would a real risk of the new currency being rejected, leading to a hyperinflationary event.
Its easy to think of how a country’s situation with a new currency might be better, but the transition would be so appalling, that it isn’t a realistic option.
Why is this step toward solution a more comprehensive one than the LTRO solutions from late 2011 . Are these solutions being created as they go or have smart people like JKH and the like, already come up with many of these types of solution in the “Lab” and waiting to see just how they work in real life. I mean this in a respectful way in that highly intelligent and Public banking educated people are indeed putting their heads together to move things in the correct direction.
But what is the basic belief system of these scholars that leads them in what they believe is the best direction?
There is no “belief system” that explains the OMT/fiscal austerity policy – it is a compromise of conflicting belief systems. OMT is the most the Keynesians can get from the Austrians (Germans), provided they agree to fiscal austerity.
Austerity implies cutting back on the organic economies productivity in order to pay expanding debt claims. I don’t see how any belief system can find value in that premise. Granted it does clean out deadwood. But, lowering productivity to pay more…really?? Bankers and bondholders want to be paid, but I say if you gambled you should loose. Even more insidious is the private bankers are actually gambling with the debtors own credit. It would be laughable if it wasn’t so sad.
But, consider that Greece has a ruling class that received wealth transfers from the West. This was to maintain Greece as a strategic buffer against the Soviet Union.
So, the Euro, with its structural debt problems (vectoring debt flows to commercial banks) is overlaid onto Oligarchial Greek society. Come on…the future scenario was predictable, and some did predict it.
The 100% reserve solution (Chicago plan circa 1936) was created in response to debt deflation and the problems of credit money. If this system were in place, Greece wouldn’t be haven problems. The fast feedback of their real money would have long ago forced stability. Also, the gamblers would loose as they have to back their gambles with their own real money.
And if we don’t want gamesmanship between countries, such as the Mercantilism of China and Germany…then simple, institute a bancor system like Keynes wanted. It would give politicans time to negotiate the exchange rates. Economics is really POLITCAL ECONOMY.
Even with this plan, Germany will insist on full repayment even though there is no credible plan for the Spanish people to generate the revenue to do it.
OK but..isn’t it a real first step…now everybody wil have the knee so deep in the sh** that they’ll have to move forward.
‘That is, there is no floating exchange rate between nations with a trade deficit or trade surplus because they all use the same currency. And there is no central treasury to rebalance economic disparities via taxes and spending. And lastly, there is no central bank and treasury relationship that eliminates the solvency risk at the sovereign level.’
Just wait a few years (if that) until free-floating physical gold plays the role of balancing item for global trade.
The fact there is no CB/treasury relationship to ‘eliminate’ solvency risk is a good thing by the way. Keeps the currency stable.
The other option is unlimited fiat currency creation, and that’s bad for currency stability, leading to eventual collapse.
The American/Japanese/UK approach.
Sadly, no such thing as a free lunch.
Gary, I don’t think fiat currency defenders believe in free lunches either. The gold standard doesn’t keep the money supply stable as its defenders claim. Fractional reserve banking ensures loan growth will expand the money supply, and when private sector debt is sufficiently large to kill loan demand, deflation will contract the money supply. Therefore, as long as we have fractional reserve banking, the money supply will be volatile, as it was in the 1800s, during the days of the gold standard. Fiat currency allows governments to expand the money supply as credit contracts in deflation to help keep the money supply more stable.
However, I do agree the gold standard has one virtue, which is that it acts as an external constraint on credit expansion. By contrast, central banks can always add new reserves in a fiat system as credit expands. So gold can be useful to prevent a boom from becoming too large, but it is quite dangerous during the deflationary phase.
Luke, I didn’t mention a gold standard, because we’re not returning to that. I suggest you do some reading about the Euro’s design, and freegold in general. It’s the way things are heading.
Gold as a stable store of value will keep the banks in check, as savers will choose gold over fiat. In time of course.
Here’s a link to get you started:
http://victorthecleaner.wordpress.com/2012/02/22/currency-wars-why-the-united-states-cannot-return-to-a-gold-standard/
A Bancor system that is well designed does the same thing. If a country is in deficit, there should be a drain on their money supply to make offsetting bancors. They cannot create new money in their supply to make new bancors.
The exchange rate is then politically adjusted as bancors are obviously increasing or decreasing depending on the balance of trade.
Contries can still trade each other with their own currency bypassing both a bancor system and a gold exchange rate system. But, if they denominate their debts in foreign currencies then they deserve what they get.
My problem with gold is that parasitical credit creating bankers want to ride their credit on top. Later with depressions and infaltions they create, they trade their credit for grabbing assets. They want to own the money power so bad in their madness, that they will use any entry to have a gold standard. Even using Gold to mediate exchanges between countries is dangerous to my mind, simply because these psycopaths walk amongst us (about 3 percent of the population is completely defective).
A 100 percent reseve solution gets ride of the debt problem overnight. A bancor solution allows a poltical solution to exchange difficulties.