Sunday, November 23, 2014

Reversing Europe’s Renationalization

NEW YORK – Far from abating, the euro crisis has taken a turn for the worse in recent months. The European Central Bank managed to relieve an incipient credit crunch through its long-term refinancing operation (LTRO), which lent over a trillion euros to eurozone banks at one percent. This brought considerable relief to financial markets, and the resulting rally obscured underlying deterioration; but that is unlikely to last much longer.

The fundamental problems have not been resolved; indeed, the gap between creditor and debtor countries continues to widen. The crisis has entered what may be a less volatile but potentially more lethal phase.

At the onset of the crisis, the eurozone’s breakup was inconceivable: the assets and liabilities denominated in the common currency were so intermingled that a breakup would cause an uncontrollable meltdown. But, as the crisis has progressed, the eurozone financial system has been progressively reoriented along national lines.

This trend has gathered momentum in recent months. The LTRO enabled Spanish and Italian banks to engage in very profitable and low-risk arbitrage in their own countries’ bonds. And the preferential treatment received by the ECB on its Greek bonds will discourage other investors from holding sovereign debt. If this continues for a few more years, a eurozone breakup would become possible without a meltdown – the omelet could be unscrambled – but it would leave the creditor countries’ central banks holding large, difficult-to-enforce claims against the debtor countries’ central banks.

The Bundesbank has become aware of the danger. It is now engaged in a campaign against the indefinite expansion of the money supply, and it has started taking measures to limit the losses that it would sustain in case of a breakup. This is creating a self-fulfilling prophecy: once the Bundesbank starts guarding against a breakup, everybody will have to do the same. Markets are beginning to reflect this.

The Bundesbank is also tightening credit at home. This would be the right policy if Germany was a freestanding country, but the eurozone’s heavily indebted member countries badly need stronger demand from Germany to avoid recession. Without it, the eurozone’s “fiscal compact,” agreed last December, cannot possibly work. The heavily indebted countries will either fail to implement the necessary measures, or, if they do, they will fail to meet their targets, as collapsing growth drives down budget revenues. Either way, debt ratios will rise, and the competitiveness gap with Germany will widen.

Whether or not the euro endures, Europe faces a long period of economic stagnation or worse. Other countries have gone through similar experiences. Latin American countries suffered a lost decade after 1982, and Japan has been stagnating for a quarter-century; both have survived. But the European Union is not a country, and it is unlikely to survive. The deflationary debt trap is threatening to destroy a still-incomplete political union.

The only way to escape the trap is to recognize that current policies are counterproductive and change course. I cannot propose a cut-and-dried plan, but three observations stand out. First, the rules governing the eurozone have failed and need to be radically revised. Defending a status quo that is unworkable only makes matters worse. Second, the current situation is highly anomalous, and some exceptional measures are needed to restore normalcy. Finally, the new rules must allow for financial markets’ inherent instability.

To be realistic, the current fiscal compact governing the eurozone must be taken as the starting point. Of course, some already-visible defects will need to be modified. Notably, the compact should count commercial as well as financial debts, and government budgets should distinguish between investments that pay and current spending. In order to avoid cheating, what qualifies as investment should be subject to approval by a European authority. An enlarged European Investment Bank could then co-finance investments.

Most importantly, some extraordinary measures need to be invented to bring conditions back to normal. The EU’s fiscal charter compels member states annually to reduce their public debt by one-twentieth of the amount by which it exceeds 60% of GDP. I propose that member states jointly reward good behavior by taking over that obligation.

The member states have transferred their seignorage rights to the ECB, and the ECB is currently earning about €25 billion ($32.7 billion) annually. The seignorage rights have been estimated by Willem Buiter of Citibank and Huw Pill of Goldman Sachs, working independently, to be worth between €2-3 trillion, because they will yield more as the economy grows and interest rates return to normal. A Special Purpose Vehicle (SPV) owning the rights could use the ECB to finance the cost of acquiring the bonds without violating Article 123 of the Lisbon Treaty.

Should a country violate the fiscal compact, it would wholly or partly forfeit its reward and be obliged to pay interest on the debt owned by the SPV. That would impose tough fiscal discipline, indeed.

By rewarding good behavior, the fiscal compact would no longer constitute a deflationary debt trap, and the outlook would radically improve. In addition, to narrow the competitiveness gap, all members should be able to refinance their existing debt at the same interest rate. But that would require greater fiscal integration, so it would have to be phased in gradually.

The Bundesbank will never accept these proposals, but the European authorities ought to take them seriously. The future of Europe is a political issue, and thus is beyond the Bundesbank’s competence to decide.

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    1. CommentedFrank O'Callaghan

      Soros has to be given credit for this. He has vast experience with an acute intelligence. But his most valuable characteristic is his resistance to 'group think'.
      The Euro area problem can be interpreted as dog-wagging-tail or as tail-wagging-dog. A currency union with insufficient political and social integration or a loose federation with an inflexible currency union. Something has to give and opportunists will bet on this. They have.
      I do not question Soros' integrity, his ability, his intellect, his originality, his good intentions or his character. He has interests that cannot be obscured. Does this colour his views? In fact I doubt that he is doing anything other than expressing his views. But I do not know if hedge fund management is closer to chess or poker.
      What is the way out of the Euro mess? A looser currency union with two or three or more 'Euro' s? Or a closer political union?
      Take your time to think about this. But do not forget we are dealing with Germany. And France. And Italy. And Spain. Each one of these has tried for not just European domination at least once but the world.
      We are heading for 'integration'.
      It used to be termed "Empire".

    2. CommentedH Gerken

      "In order to avoid cheating, what qualifies as investment should be subject to approval by a European authority." -- Ha ha, you have no idea how the EU process works. Greece won't get carrot without stick.

    3. CommentedH Gerken

      Why take a nation serious where the electorate votes trash parties, where their government fakes their balance sheets with Goldman Sachs. Greece has a reputation crisis and austerity is the only way out. They are the victims of their own political leadership and have to suffer the consequences. You can't blame any other creditor nation. Agreed rules have to apply or the deal is bust. Now the EU treaty is already broken. this means we are in the state of exeption.

    4. Commentedpeter fairley

      Many market participants feel threatened by Greeks voting for a suicidal party who would leave the Euro this day of 5/28/12?
      Other market participants may feel like me: More mildly threatened by Europe very busy in complexity & democracy but essentially trying to play the same dysfunctional games, leading to continued weakness, recessions and alarm for increasing EU loan extensions to poor credit countries headed for bankruptcy, such that eventually a STRONG COUNTRY LEAVES THE EURO. The stronger countries can leave the euro with a sense of damage, but hopeful that they are cutting losses; certainly they will not feel suicidal or 'playing chicken'. One of the smaller strong countries without as much Club Med bank exposure as France would be a likely candidate.
      The size of the first strong country leaving is an issue, and the rate of political contagion it inspires for other strong countries to leave the euro is an issue.

    5. CommentedMarco Saba

      "A Special Purpose Vehicle (SPV) owning the rights could use the ECB to finance the cost of acquiring the bonds without violating Article 123 of the Lisbon Treaty." I suggested a similar operation in my 2010 article here:
      But seigniorage rights have to be credited directly to the sovereign (the state or the citizenry as a basic income) as a compensation for the forfeited rights on all banking monetary rents arising from creating money out of thin air and interests. This was suggested to me by Gennaro Di Stasi, an old time companion in monetary fights. Obviously Mr Soros stand by the rentiers worldwide hoping that the sovereign issue on money rent never surfaces up.

    6. Commentedcaptainjohann Samuhanand

      The crux of the matter is " Germans must work and save and sacrifice" while the rest of Europe will spend,splash and enjoy.Now with Germans themselves opposing this, I feel break of EURO will show to the rest Germans are not NAZIs as some Spanish,Italian news papers have shown but are "hard workers". Germany must call the bluff of laggards.

    7. CommentedJohn Doe

      I think it important to ask, why Mr. Soros "cannot propose a cut-and-dried plan?"

      It is because it is very hard to admit that somethings, like currency unions (and currency pegs) cannot be done. The United States learned that lesson with Prohibition, albeit we are too stupid to remember it.

      It is time to make lemonade out of a lemon. End the Euro and accept the pain. Use the pain to create a political union.

      The United States did this after the Revolution. We had the Articles of Incorporation and the separate states, huge debt, and a severe Depression.

      Hamilton, Franklin, and Washington formed the United States and paid the debt.

      Europe's problems are political, not economic. Until that reality is accepted, there will be no solution

        CommentedOliver R

        I would argue that if the Eurozone was to take lessons from the USA after its civil war between 1861 and 1865, it would be that greater integration is the answer to problems between the northern and southern members of the currency union. The reason the USA was able to achieve rapid economic growth in what became known as the "gilded age" and transform itself into the worlds leading economic power was through greater cooperation and sharing the pain of reconstruction, rather than the wealthy northern US states hanging the sinful southerners out to dry, which seems to be what we are seeing in Europe today.

        If only Germany could see the error of its ways in trying to enforce budgetary discipline with such an iron fist, and instead promoted greater investment in countries such as Greece and Spain, then Europe may not be careering towards the messy breakup which Mr Soros predicts.

    8. CommentedProcyon Mukherjee

      The reversal in some ways is asking the lender to force the borrower into a profligacy of fiscal austerity, something that would further demean the legitimacy of the compact that the EU is drawn into as aggregate demand has moved to a grinding halt and supply is high-cost. The suggestions make the lender win at the cost of the borrower, something like the cure at the cost of the patient’s life.
      U.S. has been able to deal with the same problems without it being front page news, while the minuscule Greek debt problem makes the headlines. If one accounts for the debt situation of the state of California, the combined debt of Greece and Portugal would be put to shame. This is also part of the problem that bond markets force nations to comprehend; it only shows the power of the bond market intermediaries.

      Procyon Mukherjee

    9. CommentedStephen Pain

      It seems the idea of "good behaviour" is highly questionable - often what is deemed "good behaviour" is in accordance with those who are in a more powerful position. So for example the financial policies of Greece which were for the benefit of a people who had long been economically disenfranchised through successive military regimes - is viewed as "bad behaviour" because it resulted in a massive debt - a debt incurred through the bond market - a market that has an unparalleled influence over policy and lives. Now that Greece and other countries which exploited the same financial means as the US and the UK are forced into becoming dependents and second class members of the EU. However, if we wish to fault and moralize regarding sovereign decisions and activities in countries, might I suggest we focus on the US which has an unprecedented debt - one that cannot be paid back (unlike the Greek debt that is so tiny in comparison ) whose laissez faire attitude to the subprime fiasco which was motored solely by recklessness and greed which in turn precipitated the recession worldwide. Here we see time and time again "bad behaviour". One that has contributed to an unhealthy balance of payments. Such profligate behaviour on the back of a debt of 50- 200 trillion dollar debt is unconscionable. Yet, the US enjoys the right to castigate and pronounce upon the financial behaviour of countries that had only the well-being of its people at heart. The melt-down which is forecast for the EU is a fiction. Place all the debt on the table and the US is beholden to the EU and China. The bond trading and the credit rating agencies have acted in self interest, earning commission and wealth for those mainly domiciled in the US - that was the criticism of the former Italian prime minister, and out of all the things he had said, it was probably the only truth. We have seen a US bond trader literally dictate to Angela Merkel the terms for continuance of buying EU bonds. Suppose we were to turn round and ask the US to pay its debts? Would it or could it? Oh no. It will print more dollars. Moreover as a role model the US has driven many economies into a ridiculous service to industry ratio that has led to greater trade imbalances. Here I can see that the Greek economy could with much less effort than the US improve the ratio by expanding its agriculture sector as a transition to improving its industrial output. It can be achieved. But the problem is that the bond traders will peck away at any efforts - and refuse Greece the right to become financially independent. With regard to Germany an export led economy with prudent fiscal policies, to be lauded, there is a danger that it could use its power to influence - in the sense that the lender to borrower relationship which should be grounded in a fiduciary relationship in which the lender concerns itself with the interest of the borrower... is absent.

    10. CommentedPaul A. Myers

      Let's discuss points in order and make some implementing suggestions. Whining without a stick gets you no where.

      1. The rules failed because there was no market feedback into national economic policy making. Almost all governments will excessively borrow if allowed to. The rules need to be changed, radically or otherwise, to send economic market signals back into national political institutions.

      2. The current status quo is unworkable primarily because it is excessively rigid.

      3. The way for new rules to deal with inherent financial market instability is to make them flexible so that there is continuous adjustment of key variables. And probably some big shock absorbers.

      4. An enlarged centrally financed development bank must respond to market signals and match central funds with local government funds.

      5. If you are going to have a centralized bond issuing institution, it must be matched with a centralized revenue raising function.

      6. More voter participation in selecting political leadership at the top of the European Union. Otherwise you're going to have some sort of Paris-Berlin political duopoly with lots of jostling and not much progress.

    11. CommentedZsolt Hermann

      What seems to be clear from this overview article is that there is no financial solution for the Eurocrisis.
      So far whatever they tried made things worse, and mostly all they did was to print virtual money and cover the gaping holes, but the rotten structure continued to rot.
      Mr. Soros's 3 observations do not give us much to grab hold of.
      From the title of the article I expected a deeper meaning for "remationalization", but it remained on the superficial financial, banking level.
      But in truth the only true solution is stopping "renationalization", and continuing, or finishing the building of a totally integrated supra-national structure for Europe.
      Only a fully integrated structure can sustain economical, financial unity, economics are simply the external expression of the deeper human relationships.
      The just question is why should the Europeans choose total integration, losing some of their individualism instead of breaking up and remain as separate countries as it happened before the European Union?
      Because we live in a different world today. Not only Europe, but the whole world has evolved into this global, integral network, where we overlap on multiple levels, and we depend on each other even for our necessities.
      Today no individual or nation can sustain itself alone, or through small scale associations.
      Due to this interdependent and interconnected structure any attempt of a breakup would make people's lives even more miserable, allowing far right or far left populists to gain control, leading us to very unpredictable scenarios.
      The key is the understanding the nature of our integral system and the natural laws governing it.
      After the understanding of the system we could easily work out the actual structures we need to build based on human ingenuity and adaptability.