In this three part series (click here for Part A and here for Part B), I have cast a critical gaze upon recent developments which have caused a degree of jubilation in a continent that has not had any ‘good news’, regarding its integrity and future direction, for a while. Part A offered an overview of developments leading to Mr Draghi’s recent intervention, that coincided with moves toward a banking and fiscal union. Part B outlined the views of optimists, whom I called Euro-loyalists courtesy of their tendency to believe that, in the end, Europe’s elites will “come through”. In this part I explain the reasons why today’s Great Expectations (regarding the ECB’s intervention, banking union, Brussel’s federal moves etc.) are more likely to prive Dickensian than literal.
PART C – The Euro-critics interpretation of OMT as a non-credible mechanism that may seal Europe’s disintegration
The Euro-loyalists’ nightmare
Euro-loyalists, who are currently applauding Mr Draghi’s bold OMT move, fear one thing: that Mr Draghi’s bazooka is not credible. Indeed, to be credible, and thus have a chance of becoming the foundation of a future fiscal union, even a federation of sorts, the OMT bazooka must come equipped with a credible threat: the threat of withdrawing OMT from a member-state that fails to rein in its fiscal deficit.
Mr Draghi, in other words, can threaten to withdraw OMT support but talk is cheap and for a threat to be credible its issuer must convince the world that, when it comes to the crunch (i.e. when his terms and conditions have been violated by the other party), he will be better off ex post doing that which he threatened to do ex ante. [In simpler words, when I threaten my daughter that I shall stop breathing till I die unless she does her homework, she has every reason to ignore me, knowing that, if she does not do her homework, I will be far worse off if I carry out my threat, compared to how things will be for me if I do not carry it out.]
Let’s analyse Mr Draghi’s credibility problem in the context of a simple, though not simplistic, depiction of what we may call the Game of Two Marios (one Mario being Mr Draghi, representing the ECB, the other Mr Monti, the Italian PM; who is standing in here for any of the fiscally-stressed countries that may be applying for OMT assistance). According to the main, Euro-loyalist scenario, Mr Monti has two decisions to make, sequentially. First, he must decide whether Italy needs the ECB’s assistance so much as to apply for an ESM-EFSF program; the prerequisite for Mr Draghi to mobilise OMT on Italy’s behalf. If Mr Monti does not apply, and the markets realize that Italian bonds will not be purchased by the ECB, Italy will be consumed by the ongoing debt-deflationary spiral which caused Mr Draghi to conjure up the OMT program in the first place. Let us now see what happens if Mr Monti does apply for OMT assistance: The best scenario for Italy’s politicians is that the OMT goes ahead, harsh austerity measures are avoided (with only austerity-light being administered by Mr Monti) and, even though the deficit reduction targets are not met, Mr Draghi ‘chickens out’ and continues with his OMT (despite negative reports from the troika). Under the present circumstances, that would be the best outcome for Mr Monti and Italy. On the other hand, if Mr Draghi does cut Italy off the OMT, in reprisal for missed fiscal consolidation targets, this would be an unmitigated catastrophe for Italy, with an exit from the euro as the most likely outcome.
Taking stock, Mr Monti’s preference ordering looks something like this:
Best outcome = Apply for an OMT program, implement mild austerity contrary to the troika’s demands, and wait for Mr Draghi to continue with the OMT despite Italy’s missed deficit targets
2nd best outcome = Apply for OMT, implement harsh austerity in accordance with troika demands, achieve deficit reduction targets against a background of social and economic collapse, observe Mr Draghi continuing to print euros to support Italian state borrowing
3rd best outcome = Not apply at all for an OMT and doing the best he can without ECB assistance
Worst outcome = Apply for OMT only to be cut off it later by Mr Draghi due to failed fiscal targets along the way.
Let us now turn to the other Mario, the one heading the ECB. How does he rank the same four outcomes? We know that his best outcome would be for Mr Monti to apply for an OMT program and meet his fiscal targets. That way, Mr Draghi’s OMT will have proved successful and he will not be put in the difficult position of having to consider cutting Italy off. For similar reasons, Mr Draghi’s second best option would be for Mr Monti not to apply for an OMT – again, sparing Mr Draghi the pain of having to consider cutting Italy off. What is not clear is how Mr Draghi ranks the remaining two outcomes; the ones that would result if Italy applied for a program and failed to meet its targets. What is worse for the ECB and Mr Draghi? That Italy is cut off (on the basis of some, or several, negative troika reports), with all the catastrophic repercussions of such a move? Or that the ECB’s credibility is dented courtesy of the common observation that it does not carry out its clearly issued threats? Let’s, for the moment, keep an open mind on which of the two catastrophies Mr Draghi dreads the most.
The following diagram captures the Game of the Two Marios, showing how Mr Monti’s two decisions interact with Mr Draghi’s conundrum. Mr Monti knows that if he does not apply for an OMT (i.e. follows the left arrow at the beginning), Italy will end up with its 3rd best (or 2nd worst) outcome. Does this mean he should apply? Let’s see. If he does, he will then have to choose between introducing the harshest of austerity programs in order to achieve the troika’s fiscal demands and not doing so, in the hope that Mr Draghi will not dare interrupt the OMT for fear of a wholesale Eurozone collapse. The whole issue hinges on whether, faced with failed fiscal targets, the ECB would pull the plug on Italy (Mr Draghi’s dilemma is located at the bottom right hand side of the tree diagram, at the blacj node-circle).
To recap, a rational Mr Monti would think as follows: “If I do not apply for OMT, my country, and I, will end up with a terrible outcome (our 3rd best or 2nd worst). If I apply, then I have a choice between the harshest of austerities, that will get me my 2nd best outcome (even though the social and economic damage caused will be tremendous), or opt for austerity-light (to minimise austerity’s social costs) hoping that the ECB ranks a discontinued OMT program below an OMT that continues in spire of missed fiscal targets. Put differently, Mr Monti’s Italy will either have to apply for an OMT program or markets must feel that it can do so, if needed, and that, if it does, the ECB will not discontinue it come what may.
The trouble here is that everyone knows that, if Italy does apply, it will only implement the degree of austerity demanded of it in the case where Mr Monti estimates that Mr Draghi ranks the bottom right outcome as number 4 (in his preference ranking), assigning the third rank to a failed and discontinued OMT program for Italy. For if it were common knowledge that, faced with failed fiscal targets, Mr Draghi will not dare to withdraw OMT support for Italy, Mr Monti has good cause to breach his austerity commitments (see below for a proof). Thus Mr Draghi’s credibility with the German Parliament would be shredded and that the Bundesbank’s line would prevail, killing the whole OMT idea off and starting the process of the Eurozone’s dismantling. Game over!
In summary, the Euro-loyalists’ worst fear is that Mr Draghi has created a game that he cannot win. That the only chance of winning it is if either Mr Monti (or, more generally, the leaders of countries applying for OMT help) has a personal commitment to harsh austerity, or Mr Draghi can convince political leaders in advance that he is prepared to press the Eurozone’s self-destruct button (i.e withdraw OMT support after it has already began) whenever a member-state has failed to meet its program’s fiscal commitments. Neither condition seem likely to hold.
On the one hand, no government can genuinely come to love harsh austerity as an end-in-itself, and to be able to continue imposing it relentlessly in the face of increasing popular discontent. (Just ask Herbert Hoover or, indeed, George Papandreou.) On the other hand, no ECB President can convince politicians that he will prefer to pull the plug on an OMT program, rather than find a rationale to continue with it, if their fiscal targets are continually missed and they relent in their implementation of increasingly harsh austerity.
If I am right in the above, the diagram points to a single outcome: At the beginning of the game, Mr Monti knows that if he and Mr Draghi ever reach the solid black node (or circle) where Mr Draghi will have to choose, the ECB’s President will opt to move along the final rightward arrow; i.e. to continue with the OMT. So, should Mr Monti apply for an OMT? And if so, should he implement ‘properly’ harsh austerity? Being a smart operator, Mr Monti knows that, if he does not apply, Italy ends up with its 3rd best outcome (out of 4). But if he does apply and then adopts austerity-light, proceeding along the ‘insufficient debt reduction’ arrow, then Mr Draghi will continue with the OMT and Italy, and Mr Monti, will get to their first best ‘destination’. Markets will, sooner or later, work this out and will predict that, in the fullness of time, the Bundesbank will win the debate in Germany, thus causing the end of Mr Draghi’s Outright Monetary Transactions. At which point, the Crisis will reach a hideous crescendo.
The Euro-critics’ interpretation of Mr Draghi’s credibility problem
In the Game of the Two Marios above, the lynchpin producing the ECB’s credibility problem in the eyes of Euro-loyalists (though not in my eyes!) is the common knowledge that, once in the clutches of an ESM-EFSF-OMT program, the government of a country like Italy does not have an incentive to do its utmost to reduce its deficit to a level consistent with the troika’s aims and demands. This is a legitimate fear. Alas, it underplays seriously the true extent of the ECB’s conundrum: For even if Mr Monti acted as if a Lutheran priest determined to exact the harshest of austerities upon his brethren, and even if Italians were determined to keep him in power for as long as it takes to reach the troika’s deficit reduction targets, these targets would not be met. There are two reasons for this.
The first is the obvious problem with a country that lacks its own currency, caught up in a debt-deflationary cycle. Think Holland in the early 1930s: determined to stick to the Gold Standard, it struggled (with commendable protestant determination) to escape this cycle through cuts and more cuts; through liquidating asset price bubbles, banks, labour, companies etc. The result was it crashed and burned faster and deeper than any of the other comparable mid-war economy. The OMT’s conditionality constraints, if imposed, guarantee that the Eurozone’s Periphery will continue along its present path toward a 1930s-like Netherlands.
The second reason has to do with the dynamic links between the various member-states. In the Game of Two Marios I have ignored the rest of Europe, concentrating on the interaction between the ECB and one nation state, Italy. The problem, of course, with the Eurozone are the linkages which create a Mexican Wave of insolvencies running throughout the currency union. In a much earlier piece I had constructed a cross-diagram depicting this brutal dynamic. For convenience I paste it below (for its explanation please refer to the original article here or to the Appendix below).
Mr Draghi’s OMT will do nothing to annul this deconstructive process predicated as it is upon serial austerity drives. Looking at the top right hand side of the diagram, it is now clear that the Eurozone Crisis has climbed up the downward sloping 450 line (as predicted by that analysis) to the extent that the ‘fallen’ member-states are not only fallen because of high interest rates/spreads but because the Crisis has caused (a) massive capital flight and (b) a frenzy of asset liquidations which then feed the capital flight.
Once in this phase, the Crisis could only be ended if the ECB’s interventions were a given come-what-may. Instead, Mr Draghi, in order to carry with him the majority of the ECB’s Council, had to tie OMT up to an impossible commitment: that fiscal consolidation was a matter of political will and that political will was enough to dissolve the dynamic which the above diagram depicts.
Mr Draghi ingeniously passed his OMT through the ECB Council by claiming that it was not a scheme to fund governments. He could not have said otherwise, without being taken to task for violating the no-bailout clause of Europe’s Central Bank. However, conditionality (i.e. tying up an OMT program for a specific country to its submission to a troika program) was not necessary in this regard. Mr Draghi could have announced his own version of Quantitative Easing, without limiting his purchases to Peripheral bonds, and justify it on purely monetary policy grounds (using a combination of the arguments he used and those of Mr Ben Bernanke of the Fed).
Alas, it became necessary to impose (troika-supervised) fiscal constraints upon his own hand into order to appease potential dissenters, e.g. Mr Asmussen within the ECB and indeed Mrs Merkel without. Thus emerged the blending of OMT with troika-supervised austerity which hinges on the credibility that the ECB will cut off OMT for any country failing to pass a troika test.
Mr Draghi seems to believe, along with Euro-loyalists, that:
(a) it is a matter of political for countries like Itlay will to meet the troika-supervised EU-IMF-ECB conditions, and
(b) his commitment to pull out of OMT if these conditions are not met can be rendered credible.
Me Draghi is, unfortunately, wrong on both counts.
By tying up his credibility on the denial of the underlying dynamic that has brought us this Crisis in the first place, he has created a monster that will inevitably turn around and bite him. Italy and Spain (just like Greece, Portugal and Spain before) will apply for an ESM-EFSF-OMT program only when their situation is so desperate that their commitment to deficit reduction (via harsh austerity) lacks credibility, in turn wrecking the ECB’s own credibility regarding the threat to discontinue an OMT program when deficit reduction falls through.
This sequential credibility loss will mean one of two things: Either the markets will soon see through OMT, and the Crisis will be back before it even gets a chance to prove its worth. Or, once OMT have began (say, with Spain or Italy), either a significant country will be thrown to the dogs and out of the Eurozone’s pen (i.e. its OMT will be discontinued) or the German government will lean heavily upon the ECB to put an end to, effectively, all OMT programs. Either way, the Eurozone will not be able to survive these strains and, naturally, the Euro-loyalists’ dream of gradual federation will wither.
In this three part post I asked a simple question: Have recent developments given us grounds for hoping that Europe is, finally, getting its act together. A string of ‘goods news’ stories have, indeed, blown fair winds into the sails of optimists, Euro-loyalists I choose to call them, who claim that Europe is now showing signs of moving in a right direction with a speed that, while not earthshattering, will outpace the Crisis. Noises about a banking union from Brussels, the German Constitutional Court’s decision not to block the ESM, Mr Baroso’s bold plan for a Federal Europe and, above all else, Mr Draghi’s poignant Outright Monetary Transactions (OMT), these are the developments that give a semblance of a Europe regaining its poise and embarking upon a path to ‘more Europe’.
There is little doubt that recent moves would be unthinkable only very recently. A German Chancellor arguing in favour of central supervision of banks, a german member of the ECB’s Executive Board supporting unspecified purchases of Italian and Spanish bonds, a European Commission position paper outlining federation in the next few years; all these ought to be earthshattering developments that warm the hearts of those of us who think that the disintegration of the European Union, with all its many faults, would be a major blow to future generations worldwide.
And yet, as the patient reader of this long article will have surmised, I fear that these momentous developments leave us precious little room for optimism. The main reason is that, behind the discussions on the minutiae of banking unions and OMTs, a Titanomachy rages; a clash of Titans that is muffled but perfectly capable of destruction of an order that is unimaginable. We can only sense these battles from the way that ‘small matters’ (e.g. whether the ECB will be supervising all the banks or just the ‘systemically’ important ones) puzzlingly manage to bring our leaders to unexpected dead ends. For underneath the surface, on which we notice these seemingly minor disagreements, there are Titans (e.g. Deutsche Bank) who are lashing out mercilessly against each other and against the revelation of their interests and situation (e.g. their insolvency, which German banks want to keep out of sight by keeping their various tentacles in the shadow banking world out of the ECB’s reach and oversight). Like the mythological Titanomachy so here there are various clashing Titans and a variety of alliances of convenience between them. Europe’s institutions may well prove too flimsy to contain their struggles, especially so as the Great Recession (which has become a Great Depression in parts of the Periphery) are robbing them of the oxygen of popular support and democratic legitimacy. Tragically, even the best meaning politicians and apparatchiks (e.g. the two Marios), are being forced by the underlying Titanomachy into games that they cannot win, with Europe and the world at large ending up as the grand losers.
Appendix – The cross diagram explained
For the readers’ convenience I copy below the explanation of the four part cross diagram which featured above:
The purpose of any cross diagram is to combine four diagrams in one in a manner that makes it easier on the eye to see the interconnections between its parts. To read this particular cross diagram, please note that all axes are positive. For instance, in the bottom right part of the diagram, a downward movement signifies an increasing α(F). Similarly, in the top left part, a leftward movement signifies an increase in s, the eurozone’s average spreads. Having established these simple conventions, it is time to define our four axes.
Top right diagram: The horizontal axis counts the number of solvent member-states. At the outset, i.e. just before the Crisis set in, all N member-states fell in that category. After the first member-state ‘fell’ (i.e. Greece), the number of solvent member states diminished to N-1 (see the horizontal axis) whereas the number of ‘fallen’ states F (see the vertical axis) went up to one. With every member-state that ‘falls’ we climb one notch up the straight line.
Bottom right diagram: Here we find the relationship between the EFSF’s toxic ratio α(F) and the number of ‘fallen’ member-states F. With every new member-state that ‘falls’, we move to the left of the horizontal axis and α(F) rises along the thick red curve. This simply signifies that as more countries fall prey to the Crisis, and require official bail outs from the rest, the remaining solvent countries are facing a rising α(F): Put differently, the ratio of the debts that the solvent must now guarantee over their aggregate GDP increases even if the eurozone’s aggregate debt and aggregate GDP remain the same (indeed, even if the eurozone’s aggregate debt-to-GDP ratio is constant or falling!).
Bottom left diagram: The new axis added here (that runs from the cross diagram’s centre leftward) is the average of the interest rate spreads (i.e. the average difference of member-state interest rates from the lowest interest rate in the eurozone, i.e. Germany’s) facing eurozone’s still solvent states. What happens when α(F) rises in response to the ‘fall’ of a member state that has recently made the awful transition from being an EFSF donor to an EFSF recipient? The simple answer is: Interest rate spreads rise throughout the eurozone. This simple truth is captured here by the blue curve s(α): E.g. When Ireland ‘fell’, α rose and the markets got more jittery about the capacity of Portugal, the new marginal member-state, to shoulder not only its own debt burden but also the added burden of its contribution to the Irish bail out. Markets, in these circumstances, react (naturally) by pushing up the spreads of still solvent nations with a high-ish debt-to-GDP ratio and relatively sluggish growth. Thus, the positive relationship between a(F) and s in this part of our cross diagram.
Top left diagram: Each member-state has a limit beyond which it cannot refinance its existing debt when the interest rates it is called upon to pay reaches a certain threshold level. This is what happened to Greece in May 2010, to Ireland a few months later, to Portugal in the Spring of 2011 and, soon, to Spain and Italy (which will run out of money in September 2011 and February 2012 respectively). In this, final, part of the diagram, the assumption is that pre-crisis average spreads equalled s0. The other values of s, si, depict the level of average spreads facing still solvent member-state i above which it too ‘falls’ and joins the EFSF list of recipient states.
Let us now use this diagram to answer the original questions: Why Italy and Spain? And why is the actual size of the EFSF immaterial? Let us begin our account at the two points that the diagram marks as starting points: In the top right diagram it is point N on the horizontal axis (corresponding to the initial condition when no member-states had yet ‘fallen’) while in the top left diagram it is the average interest rate eurozone spreads level s0 (on the horizontal axis). For reasons that I shall not discuss here, at some point average spreads began to rise sometime toward the end of 2009. When they reached level s1, this triggered the Greek crisis and, after many trials and tribulations, the Greek bail out of May 2010. Once Greece had fallen, the average contribution of each of the remaining member-states, which hitherto equalled zero, rose to level α1. The result was a further increase in average spreads until s reached s2, thus causing Ireland to ‘fall’. [The reader ought to trace the continuous arrow that begins at s0 (see top left diagram), shifts leftwards to s1, then jumps up until F rises from 1 to 2 (i.e. Ireland joins Greece – see top right diagram), then proceeds to the bottom right diagram pushing α to α2 before migrating again to the bottom right diagram where it pushes average spreads to s3, a level that throws Portugal off the cliff etc. etc.
There are two points to note here, before moving to my concluding remarks:
First, the best we can say about our European leaders is that maybe they had hoped that the gradient of curve s(α) would prove less steep and, thus, might have prevented the cobweb-like explosion from occurring. If so, they ought to have known better. For the slope of this curve is not cast in stone but is predicated upon the psychology of the markets. In view of the gross uncertainty at a global level, to bury a toxic ratio, like α(F), in the foundations of your anti-Crisis apparatus (the EFSF) is to ask for trouble.
Secondly, Germany and the rest of the surplus countries were hoping that the loan guarantees that they were offering to the EFSF would never need to turn into actual cash transactions. This would, indeed, be so if the EFSF had a coherent structure: its very institution would have averted speculative games by market traders and German taxpayers would never have had to cough up the euros associated with the loan guarantees to the EFSF. But, with the toxic α(F) inside the EFSF’s foundations, markets recognise the shape of the cross diagram above. And nothing pleases them more than an opportunity to bet against an official’s incredible threat, promise or prediction. If only for this reason, it was insanity personified to imagine that the α(F) curve might turn out slight enough to help contain the contagion. In short, our leaders ought to have known better.