PART B – Mr Draghi’s nod to Euro-loyalists
On 8th August 2012 the President of the ECB acknowledged that the Eurozone was at an advanced process of disintegration and, in the same breath, promised to do what it takes to put a stop to it. On September 6th came his OMT announcement that many commentators see as a game changer. While most acknowledge that it will not suffice as a weapon with which to win the war against the Crisis, it has given Euro-loyalists a chance to argue that, in the end, Europe has a way of resolving its crises. The fact that the OMT announcement overlapped, time wise, with the impressive document issued by the European Commission regarding the formation of a proper banking union and, also, the German Constitutional Court’s grudging acceptance of the right of the ESM to exist, gave rise to a collective Euro-loyalist sigh of relief.
For the purposes of, as they say, full disclosure, these lines are written by a Euro-critic, though definitely not a Euro-clast (see Part A for the distinction). I am saying this because one would be excused to think that, as a Euro-critic, I have a vested interest in seeing Mr Draghi, Mr Baroso and the rest of our European leaders fail in their quest for a solution predicated upon the basic assumptions and policies that have, so far, not been revised or amended. For my part, all I can do is try to look at the new situation without prejudice and with a fresh analytical eye. So, let’s take a fresh look at the situation the Eurozone is facing: Have Euro-loyalists been vindicated?
The Euro-loyalist position was that, in good time, Europe will rise to the occasion and will create the institutions necessary for overcoming the Crisis threatening the euro. What are the minimum institutions necessary to accomplish this? I think we all agree that there are three: First, a proper banking union. Secondly, a buffer between the national debt of different member-states that prevents a sequential run on their bonds. Thirdly, a strategy for dealing with a dearth of aggregate investment and with internal imbalances (of investment, capital flows and trade) – what I like to call a Surplus Recycling Mechanism. How much closer is the Eurozone to getting these three institutions up and running before the Crisis wrecks its foundations completely?
Starting from perhaps the last of the three missing institutions (the Surplus Recycling Mechanism), there is little to say, save for the observation that it is not even on the agenda. It is quite instructive, and sad, that in the case of the, say, Greece, the European Investment Bank, instead of being the pillar of all attempts to help the collapsing social economy grow, has been neutered by the unfolding fiscal and banking crisis. While Greece has 12 billion euros pending from Brussels (unspent structural funds for the 2007-2012 period), the European Commission is only channelling 1.44 billion to the EIB for investments in Greece. Without any plans for a pan-European investment strategy, centred around the EIB, Europe’s growth and rebalancing prospects are looking very dim.
Regarding the Banking Union, we have a clash of titans brewing. A new Titanomachy is raging, as these lines are written, between German bankers adamant against any serious supervision by the ECB and the Commission which has issued a splendid paper on what Europe’s banking system should look like within a few years. The Titanomachy in question is neither visible to the naked eye nor is its outcome predictable. As I have written elsewhere, the German Finance Ministry is adopting the language of a banking union in order to deny the substance. This does not augur well for a banking union that succeeds in its main task: to de-couple the banking crisis from the crisis of national debt in the Eurozone’s Periphery.
Let us now turn to the other institution which is sine qua non for ending the Crisis: how to finance the stricken nations, Italy and Spain more significantly, that are caught in the clutches of a postmodern Gold Standard, unable to finance themselves, at a time of vicious recession. What would take to end this? Whatever institution is created, it must be centred upon the ECB and must find a way of bypassing the no bailout clause that was the ECB’s foundation stone. In our Modest Proposal, Stuart Holland and I have outlined a simple way of doing this: the ECB acts as a go-between member-states and financial markets, borrowing on their behalf at attractive rates and organising a credible repayment mechanism which would see to it that the new loans are repaid by the national governments, thus ensuring that the ECB need not monetise their debt (either at the primary or at the secondary markets). The only serious argument against this proposal, that I encountered amongst policy makers, was that this would give the ECB a role that no other Central Bank has ever had. Germany, apparently, is eager to ensure that the ECB abstains from ‘innovative’ Central Banking. Our proposal struck them as too innovative at a time when minimum innovation was a political imperative.
The only other serious alternative being discussed at the time was to give the ESM-EFSF a banking licence, allowing it to lever up its loans to the stricken member-states using the ECB’s balance sheet. I opposed this idea because I considered the very structure of the ESM-EFSF toxic (especially when bank recapitalisations add new debt to the sovereigns that fund the ESM-EFSF, and which may need funding from the latter). Levering up a toxic fund was not our idea of good policy. Still, the US Federal Reserve, the French government, and possibly a majority of the Eurozone’s Periphery secretly hoped that the ESM-EFSF could get its banking licence. Well, it did not. Yet, Mr Draghi’s eventual ‘solution’, his OMT, comes pretty close to this.
Under an ECB-turbocharged (or leveraged) ESM-EFSF, the Eurozone’s bailout fund would borrow say 5 euros for each euro that it was funded with by governments in order to lend to countries like Italy and Spain, under strict IMF-troika-like conditionalities of course. This was deemed politically, even morally, unacceptable by Mrs Merkel, by the German constitutional court, by German public opinion etc. So, what will the OMT do differently? Not much, according to Gavyn Davies. Here is Davies’ argument:
Under Mr Draghi’s OMT, Spain will have to submit to a strict IMF-troika-supervised fiscal adjustment program. Once the program is approved, the ESM-EFSF will lend monies to Spain directly (i.e. purchase Spanish bonds in the primary market) while the ECB fires up its digital presses to create the money with which it will purchase many more ‘second hand’ Spanish bonds (of a maturity that does not exceed 3 years) in the secondary markets.
While Gavyn Davies has a point, I think there is an important difference between the ECB-leveraged ESM-EFSF idea and OMT. Under OMT, the ESM-EFSF will be more limited in how many fresh bonds it can buy (as its funding is severely circumscribed). This means that Mr Draghi will have to print a lot more money so as to direct it to the secondary market so as to keep Spanish interest rates low. In reality, his OMT is a less efficient version of the ECB-turbocharged ESM-EFSF model. The political significance of this is that the ECB will face more flak than necessary from the Bundesbank for achieving the same compression of interest rate spreads within the Eurozone (as it will have to print more money to achieve the same effect that an ECB-leverage ESM-EFSF would have). Still, to be fair to Mr Draghi, he may well reply that the OMT’s merit is that, unlike the ECB-leveraged ESM-EFSF plan, it was possible to sell it to the German polity now. In essence, short term political acceptance in Germany was bought at the cost of greater long term German opposition to the ECB’s operations; a point that resonates with Wolfgang Munchau’s analysis.
Be that as it may, the question is how effective the OMT system will be in providing a proper “buffer between the national debt of different member-states that prevents a sequential run on their bonds”. It all depends on whether bond market participants take a look at it and decide that it will not pay them to bet against its integrity. Will speculators wager a few billions that ‘unspecified bond purchases’ means something different to ‘unlimited bond purchases’? Will they want to bet perhaps that, in the end, the Bundesbank will win the argument against Mr Draghi, thus pulling the rug from under his feet? It will also depend on what the OMT means for countries that are already in the clutches of troika programs. Will the ECB be purchasing Irish, Greek and Portuguese bonds in the secondary markets? Will the spreads that the ECB aims at for each member-state be the same? If not, who will determine, and on what basis, the difference between these target spreads? The ECB itself? Europe’s political leaders? Is it possible to imagine that a country like Greece is turned into a kind of Kosovo (a protectorate with the euro as its only currency but with no functioning state, a derelict banking sector and a disheartened mafia-ridden society whose only export is its people plus tourism) while the OMT successfully saves Spain and Italy?
Euro-loyalists will probably answer that it is too early to be negative about Mr Draghi’s OMT. That this is only one step in the direction of a fiscal union, a Federal Europe; as evidence by Mr Baroso’s recent bold statement. Their only worry is that the OMT’s success, even the ebullience that its announcement caused, will alleviate the pressure on governments that keeps them on the straight and narrow, thus raising the prospect of a negative troika report which, in turn, will force the ECB to withdraw its OMT assistance to the said member-state; at which point the latter will face a serious prospect of ejection from the Eurozone, therefore landing us back to the present mire of, in Mr Draghi’s words, “convertibility risk” (the euphemism he coined for Euzone disintegration). Still, Euro-loyalists hope that, before such a cul-de-sac is reached, Mr Baroso’s plans for the Eurozone’s federation will be so advanced that the centrifugal forces will be tamed.
In summary, Europe is currently in the clasps of a ruthless Titanomachy. In the red corner, the German banks are struggling with all the force they can muster to avoid a proper banking union. They are joined by a Bundesbank determined to stick to its guns, undermining Mr Draghi’s efforts to monetise part of Spain’s and Italy’s debts so as to compress the interest rate spreads between the core and the periphery which guarantee the common currency’s, and the single market’s, failure. Over at the blue corner we have Mrs Merkel, Mr Hollande and Mr Barosos who have formed an alliance of convenience backing Mr Draghi. For the time being they are keeping the German bankers (private banks plus the Bundesbank) at bay. But their greatest enemy is silent, sinister and is working away underground, eating into the Eurozone’s foundations. Who is that enemy? The unrelenting logic of disintegration buried deeply into the recessionary macrodynamics of today’s austerian Eurozone.
PART C – The Euro-critics nightmare: Europe continues to disintegrate despite Mr Draghi’s OMT
[To be continued tomorrow]