Greece keeps pushing the currency union envelope. Mr. Tsipras, the socialist prime minister, is driven by his ideological convictions and therefore plays a different game than the leaders in Brussels with whom he is negotiating to keep his country afloat. The problem for the European leadership is that it seems incapable of understanding what role Tsipras’s ideology plays for his actions – Tsipras wants full independence for Greece so he can build his version of the socialist dreamland that now-defunct Venezuelan president Hugo Chavez created.
Rational arguments such as “property rights no longer exist in Venezuela” or “they have 60 percent inflation” and “crime is rampant and there is a shortage of almost every daily necessity” do not work on ideologues like Tsipras. That is the very problem with them. Therefore, you cannot reason with them as though they were swayed by the same type of “sensible” arguments that you are. But more importantly: so long as the EU leadership does not understand that politicians like Tsipras are ideologically opposed to everything that the EU stands for, they will not be able to have a rational conversation. There will be constant discords, where the EU leaders try to set goals that will help Greece stay inside the euro zone – and ultimately the EU – while Tsipras and others like him (think euro skeptics in Italy and Spain) will try to create circumstances that allow them to get what they want, namely out of the euro zone (and eventually the EU).
The biggest danger with this discord is that once the euro zone starts breaking apart, the retreat from the common currency will be disorderly. There is no doubt that the Bundesbank in Germany has a contingency plan for that disorderly dissolution, but it is far from certain that their plan will work. There are so many uncertain factors in this game that an even reasonably confident prediction is out of the question.
That said, there are some fixed points that can be put in the context of macroeconomic reasoning. That in turn should at least provide some insight into the best and worst case scenarios.
Before we get there, though, an update on the Greek situation, as reported by the EU Observer:
The stand-off between Greece and its lenders deepened over the weekend ahead of a meeting of euro finance ministers on Friday (24 April), with both sides exchanging barbs over the risk of a Greek default and its consequences for the eurozone. On Friday, Eurogroup president Jeroen Dijsselbloem said both parties should avoid “a game of chicken to see who can stick it out longer. We have a joint interest to reach an agreement quickly”.
An agreement about what? If Greece secedes from the euro it can, at least theoretically, run away from its bailout-related deals. In practice, the EU would still want to enforce loan contract, but it is much more difficult with a country that has a currency of its own – a currency that in all likelihood will be depreciating rapidly.
As for the IMF, Greece would have to deal with them separately, but it could do so much more so on its own terms once outside of the euro zone.
In fairness, though, it looks like the full extent of the Greek situation is beginning to dawn on at least some EU leaders. The EU Observer again:
EU and International Monetary Fund (IMF) leaders warned that Greece had to make quick progress to finalise a list of reforms that would enable it to receive a €7.2 billion loan. But they hinted that a Greek default could be managed by the eurozone. “More work, I say much more work is needed now. And it’s urgent,” said European Central Bank (ECB) chief Mario Draghi in Washington, where he was attending the IMF’s Spring meeting. “We are better equipped than we were in 2012, 2011, and 2010,” he added, referring to the years when fears of a eurozone break-up were at a high. “Having said that, we are certainly entering into uncharted waters if the crisis were to precipitate, and it is very premature to make any speculation about it,” Draghi also said.
So what would happen if Greece seceded from the euro? Well, the EU Observer article brushes on that subject:
Greek finance minister Yanis Varaoufakis, for his part, warned that his country’s exit would cause major problems for the rest of the region. “Some claim that the rest of Europe has been ring-fenced from Greece and that the ECB has tools at its disposal to amputate Greece, if need be, cauterize the wound and allow the rest of the eurozone to carry on,” he said on Spain’s La Sexta channel “Once the idea enters peoples’ minds that monetary union is not forever, speculation begins … who’s next? That question is the solvent of any monetary union. Sooner or later it’s going to start raising interest rates, political tensions, capital flight.”
This is a key statement. Some would interpret it as Greek leverage in negotiations with Brussels. However, the correct way to read it is as a blunt warning of what is to come: sooner or later Greece will leave the currency union, and it will do so like the men who escaped Alcatraz in 1962. Once someone has done what everyone thought was impossible, then just as Mr. Varaoufakis says, the only question on everyone’s mind will be: who’s next?
British Member of the European Parliament for the UKIP, Mr. Nigel Farage, made a great point recently when appearing on BBC (at about 2:25 into the video): the initial effect of a Greek currency secession is going to be a boost in growth as the currency depreciates. This growth spurt will inspire other struggling euro-zone states to consider a return to their national currency. Once the secession movement gets off ground, it is uncertain how many states will actually reintroduce their national currency, but it would be reasonable to expect a first round of secession to sweep from Athens to Lisbon.
The short-term financial turmoil aside, the most likely effect will be a southern European currency war. The four countries that have historically had weak currencies will find themselves returning to that position, only with an even deeper macroeconomic ditch to climb out of. The only moving part of their economies is, actually, exports, which will get a boost from a rapid currency depreciation. At the same time, that depreciation will be a major conduit for imported inflation, which in turn will eat its way into the economy a bit after the exports boom has gained momentum. The more the currency depreciates, the stronger the imported-inflation effect will be.
Inflation will have major consequences for the government budget. Depending on what type of inflation indexation is built into the welfare state’s entitlement programs, the cost of government spending will rise more or less with inflation. While inflation can also be beneficial to the revenue side of the state budget, it negatively influences the purchasing power of households and generally (but not always) depresses business profitability. As a result, domestic economic activity slows down, causing the tax base to stagnate.
And this is where the major test comes for currency secessionists: how will they handle their budget problems? With weak currencies they will have a hard time selling their treasury bonds on the international market; they can load up their banks – a likely scenario in Greece where a Syriza government could even go as far as to nationalize banks – but as the Great Recession demonstrated, leaning on banks for funding a government deficit is a particularly bad idea. When banks are overloaded with bad government debt in the midst of a macroeconomic crisis, then suddenly it is 2009 again.
Very briefly, then: once the euro zone starts falling apart the first ones to leave will face very difficult challenges. That is not to say that the remaining euro zone countries will have a better life – it is very likely that the euro zone itself won’t survive the 2017 French presidential election – but once the Southern Rim has left the euro zone the remaining countries will have a somewhat easier time following an orderly retreat plan. In fact, it would not be surprising if Germany, Austria and the BeNeLux countries remained in a “core” currency union – a Gross-Deutsch Mark, if you will. That currency could actually become a stabilizing point for a post-euro EU.
Still, even with an anchor currency in the heart of the EU, an implosion of the euro will have major negative effects for the European economy. What will those effects look like? That is a subject for another article.
For more than a year the European economy has been in deflation territory. To reverse that trend the European Central Bank launched its Quantitative Easing program, aimed at flooding the euro zone with liquidity. According to crude monetary theory this will drive up prices in line with the so called quantity theory of money; few if any central bankers would admit that their take on money supply and inflation is this simple, but the only other explanation is so far-fetched that even the quantity theory of money makes sense.
The alternative theory says that the reason why businesses are not investing in Europe is that there is not enough cheap risk capital available in the economy. For this theory to work, though, the cost of borrowing that businesses face would have to have been exceptionally high during the recession. In fact, the exact opposite is true: since the Great Recession started the composite cost of borrowing for non-financial corporations in the euro zone has been in the 2-4 percent bracket. Right before the recession it topped out above ten percent.
In other words, the has been an abundance of liquidity available for anyone and everyone willing – and qualified – to borrow.
But if your business outlook says flat sales, at best, you are not going to take on new loans. And flat sales or worse has been the forecast story for European businesses for six years now.
What does this have to do with inflation? Well, low economic activity means low demand and low utilization of productive capacity. As a result, there is no upward pressure on prices and therefore no real-sector inflation in the economy. Whatever inflation may be looming in the near European future has a monetary origin.
Does this mean that the primitive quantity theory of money is correct? No, it does not. The quantity theory rests on a rigid structure of assumptions regarding the operation of a free market, both in terms of the flexibility of real-sector resources and of free-market prices. The most confounding part of the quantity theory of money is that the economy axiomatically always reverts back to full employment; then, and only then, can monetary inflation occur.
Europe is about to line up with several other countries proving that monetary inflation is just as possible – if not more possible – in a stagnant economy. In fact, when stagnation and low capacity utilization is combined with monetary inflation, there is a macroeconomic venom brewing. The worst response to this situation is one where key decision makers assume that the monetary inflation they see is actually real-sector inflation.
Somewhat surprisingly, that mistake is made by Ambrose Evans-Pritchard, who is without a doubt Europe’s best political commentator. But in his latest column in The Telegraph, Mr. Evans-Pritchard allows his otherwise astute analytical abilities to lead him astray:
Be thankful for small mercies. The world economy is no longer in a liquidity trap. The slide into deflation has, for now, run its course. The broad M3 money supply in the US has been soaring at an annual rate of 8.2pc over the past six months, harbinger of a reflationary boomlet by year’s end. Europe is catching up fast. A dynamic measure of eurozone M3 known as Divisia – tracked by the Bruegel Institute in Brussels – is back to growth levels last seen in 2007.
But GDP growth, business investments, employment and capacity utilization are far from 2007 levels. While inflation back then was a real-sector phenomenon, it is not founded in real-sector activity today.
And that should have us all worried. Evans-Pritchard included:
History may judge that the European Central Bank launched quantitative easing when the cycle was already turning, but Italy’s debt trajectory needs all the help it can get. The full force of monetary expansion – not to be confused with liquidity, which can move in the opposite direction – will kick in just as the one-off effects of cheap oil are washed out of the price data.
I know Mr. Evans-Pritchard is British, but that does not mean he has to entertain an erstwhile concept of liquidity. Just a small comment. Back to his column, where his discussion of inflation is taking a somewhat odd turn:
Inflation will soon be flirting with 2pc across the Atlantic world. Within a year, the global economic landscape will look entirely different, with an emphasis on the word “look”. In my view this will prove to be mini-cyclical in a world of “secular stagnation” and deficient demand, but mini-cycles can be powerful. Mr Stein said total loans in the US are now growing at a faster rate (six-month annualised) than during the five-year build-up to the Lehman crisis.
Again, all macroeconomic indicators point to a continuation of a ho-hum recovery here in the United States, the March GDP numbers notwithstanding. At the same time, practically nothing says that Europe will enjoy anything near a U.S. growth period any time soon. Therefore, it is wrong to compare the inflation rates in Europe and the United States as if they are apples and apples. They are not. Our inflation here in the United States is the result of a steady rise in economic activity, a tightening of available capacity in infrastructure and other capital stock and even a glimpse of labor shortage in some sectors.
In other words, traditional causes of inflation. Europe, on the other hand, still suffers from almost twice the unemployment rate, with GDP growth at half or less the rate of ours. To really drive home the point about Europe’s abundant, idling economic resources, let us once again repeat the point that the cost of borrowing for non-financial corporations is down to 2-4 percent (after topping 10 percent before the Great Recession).
There is in other words no demand-driven push on prices to rise in Europe. This means monetary inflation, and there is an abundance of evidence from the past century on just how destructive and unstable such inflation can be.
Mr. Evans-Pritchard does not see this. Instead, he is worried about monetary tightening in the United States and its possible global effects:
“The risk is that the Fed will have to raise rates much more quickly than the markets expect. This is what happened in 1994,” he said. That episode set off a bond rout. Yields on 10-year US Treasuries rose 260 basis points over 15 months, resetting the global price of money. It detonated Mexico’s Tequila crisis. Bonds are even more vulnerable to a reflation shock today. You need a very strong nerve to buy German 10-year Bunds at the current yield of 0.16pc, or French bonds at 0.43pc, at time when EMU money data no longer look remotely “Japanese”.
Just one second here… No longer remotely “Japanese”? GDP growth for 2014 in the euro zone (19 countries) was 0.89 percent, and 1.3 percent in the EU as a whole. How is that not “Japanese” data??
Yet on some points Mr. Evans-Pritchard does see the underlying real-sector dimension of the inflation issue:
[The U.S. labor market] is turning. The quit rate – a gauge of willingness to look for a better job – is nearing 2pc, the level when employers must build pay-moats to keep workers. It is true that the US economy gave a good imitation of hitting a brick wall in the first quarter. Retail sales have fallen for three months, the worst drop since 2009. The Atlanta Fed’s snap indicator – GDPNow – suggests that growth dropped to stall speed in March. The rise in non-farm payrolls slumped 126,000 in March, half expectations. Yet economies do not fall out of sky. The US has already survived the biggest fiscal squeeze since demobilisation after the Korean War without falling into recession.
And again, some sectors and states are already in tight labor supply. Try hire a Hooters waitress for less than $15/hr in North Dakota. Some trucking companies are pushing annual driver compensation north of $70,000.
But perhaps the problem, at the end of the day, is that analysts and commentators focus on too many variables at the same time. You can certainly look at the economy from an almost infinite number of angles and get different stories out of each one of them, but in reality some angles only show symptoms while others capture the causes. Mr. Evans-Pritchard stretches his analysis a bit thin, going into asset prices and a roster of secondary data, elevating those numbers to the same prominence as – actually higher prominence than – real-sector growth data.
In reality, asset prices depend on real-sector growth data; tainted by speculative expectations, they only give an imperfect image of where the economy is really heading.
When we look at the European and American economies from the angle of real-sector activity, we do again see the gaping difference between a growth, moderately healthy United States and a stagnant, industrially poor Europe. The former has a sound form of inflation on its way; the latter is experiencing the beginning of a dangerous episode of monetary inflation.
That said, I still recommend you all to keep reading Ambrose Evans-Pritchard. He is intelligent and thorough and he has no problem presenting unpopular views if he believes they are merited.
When a welfare state runs out of taxpayers’ money they run a so called structural budget deficit. That is a deficit that does not go away with strong growth but remains in the government budget, theoretically forever, in practice over a period of time longer than at least one business cycle.
A structural deficit forces government to borrow continuously, i.e., to make borrowing a permanent revenue source on par with taxation. As I explained recently, of 14 member states in the European Union ten suffer from structural deficits when GDP growth is measured in current prices. When inflation is removed from the growth data, all 14 countries run significant structural deficits.
Since this deficit analysis was limited by the availability of consistent data (only 14 states) it is not possible to firmly conclude anything about the EU as a whole. However, if 14 states, selected merely because of data availability, run structural deficits, then the likelihood is pretty high that the remaining 14 EU member states have similar problems with structural deficits.
Structural deficits create a major problem for the countries whose governments have to borrow the money. The ongoing borrowing need depresses market demand for their bonds, eventually driving some countries with extreme deficits – think Greece of Spain – to have to pay massive interest premiums on their treasury bonds in order to attract buyers. To fix this, the European Central Bank came up with its own version of the American Quantitative Easing program: the central bank buys the bonds that the free market does not like.
Quantitative Easing was a bad idea in the United States, as it allowed the federal government to continue spending money without reining in its increasingly uncontrollable welfare state. In Europe, the idea is even worse: the European welfare state is more “mature” than the American, making its structural deficit problems even more serious. Therefore, the QE program will feed a government that is even farther away from being able to pay for its ongoing expenses than the U.S. government is.
Against this background, it is astounding to read the following article at EUBusiness.com:
The European Central Bank said Thursday it is increasingly confident that its controversial bond purchase programme is helping boost the eurozone’s economic recovery, even as a top official expressed doubts about its effectiveness. In the minutes of the governing council’s meeting on March 4 and 5 released on Thursday, the ECB said that “members generally shared the assessment that significant positive effects … could already be seen” from the new bond purchase programme known as quantitative easing (QE).
First of all, the QE policy is not even a quarter of a year old yet. It would not be possible to identify causalities even if we tried with an economic microscope. Secondly, even if there are visible effects, they would be limited to lower interest rates. While it is true that the ECB has entered negative interest territory and decided to stay there for a while, it is important to remember that the negative interest rate became reality long before the QE program did. Furthermore, ultra-low interest rates do not fix Europe’s macroeconomic problems anymore than they have fixed Japan’s decades-long problems.
According to EUBusiness.com there is no shortage of critics of the QE program:
[Some] prominent ECB members — notably the head of the German central bank or Bundesbank Jens Weidmann and ECB executive board member Sabine Lautenschlaeger — have repeatedly expressed doubts about the need and impact of such a programme. Lautenschlaeger told a German magazine on Thursday that she had “doubts whether the economic effects of the purchase programme will reach the desired magnitude.” And she warned that the current very low level of interest rates could lead to the formation of asset price bubbles. Before joining the ECB’s executive board, Lautenschlaeger was vice president of the German central bank and she shares the same scepticism as Weidmann.
But the monetary Eurocrats seem to be dead set on finding something positive to report. EUBusiness.com again:
Nevertheless, at the governing council’s last policy meeting in Nicosia, Cyprus, in March, there appeared to be agreement that QE was indeed helping to ease financial market conditions and the cost of external finance for companies, the minutes showed. Coupled with recent positive economic data and signs of a turnaround in inflation, “this provided grounds for ‘prudent optimism’ regarding the scenario of a gradual recovery and a return of inflation rates to levels closer to 2.0 percent,” the minutes stated.
This is actually disingenuous. Corporate borrowing costs have been declining since the Great Recession started. They started falling because banks still wanted to lend to non-financial corporations, but the non-financial corporations refused to take on more debt. They were simply far too pessimistic about the future of the European economy.
In short: low corporate borrowing costs have absolutely nothing to do with QE.
All in all, it sounds like the ECB is desperately trying to grab for positive news. this makes them prone to overlook the risks associated with QE, one of them being that governments simply decide not to do much more about their notorious deficits. This means, simply, letting the structural deficits remain as they are, whereupon the underlying problem in the European economy – an over-bloated welfare state – remains unsolved.
Sweden has joined the club of runaway monetary policy. From Reuters:
Sweden shocked markets on Thursday by introducing negative interest rates, launching bond purchases and saying it could take further steps to battle falling prices. The central bank joins a list of those including the European Central Bank, the U.S. Federal Reserve and the Bank of England, to resort to unconventional monetary policy steps to confront an unusual combination of economic problems.
No. The Federal Reserve has reversed course. And together with The Bank of England the Fed has been helped by the fact that it is operating in an economy with moderate taxes and relatively relaxed fiscal policy. The ECB has opened the monetary flood gates in an economy that is plagued by statist austerity and more or less zero growth.
In fact, the slight uptick in economic activity in the third quarter of 2014 that I reported on earlier this week is closely correlated to the all-out liquidity bombardment that the ECB began early summer last year. On the margin there are those who will take advantage of declining interest rates. According to data from the ECB, euro-denominated loans to non-financial corporations declined noticeably in 2014. In the group of loans with a 5-10 year rate fixation, the interest on loans above 1 million euros fell by more than one percentage point, from 2.9 percent to 1.73 percent. Other collateral loan categories saw smaller declines, but the downward trend is unmistakable.
It is likely that the same thing will happen in Sweden; the question is what effect lower interest rates will have on economic activity. In the EU, gross fixed capital formation – a.k.a., business investments – did actually increase in 2014. However, broken down by quarter, the annual growth rate (i.e., over the same quarter the previous year) looks much different:
- Q1 2014 up 3.78 percent;
- Q2 2014 up 2.35 percent;
- Q3 2014 up 1.86 percent.
In other words, the largest annual increase was recorded before the ECB declared a negative interest rate. It remains to be seen what happened in the fourth quarter, but even if there was an increase somewhere in the same territory as earlier in 2014, the big question is what the lasting impact is going to be on GDP growth and employment. One indicator of this is private consumption, which seems to have benefited a bit more from the ECB’s desperate interest rate cuts. Again measured as annual increases by quarter:
- Q1 2014 up 0.68 percent;
- Q2 2014 up 1.27 percent;
- Q3 2014 up 1.4 percent.
For the two years Q3 2012 to Q3 2014 the annual increase was, on average, 0.3 percent. Nothing to be jubilant about, but the modestly accelerating trend during 2014 indicates a stabilization (rather than some sort of genuine recovery).
What does this mean for Sweden? The problem with that particular country is that its private-consumption increase is inflated by recklessly high household debt levels. These levels, in turn, are held up by mortgage loans with absolutely irresponsible terms, such as interest-only payments or basically life-long maturity periods. As I explained in my book Industrial Poverty, if Swedish household debt had remained a constant share of disposable income from 2000 and on, its private-consumption growth rate would almost have stalled.
Put bluntly: Sweden appears to be in reasonable economic shape only because households have increased their debt as share of disposable income from 90 percent 15 years ago to 180 percent today.
What this means is, plain and simple, that it is exceptionally irresponsible to make more credit available at even lower costs. But it also means that on the margin, the Swedish Riksbank will get less new economic activity out of every negative interest point than the ECB gets; the higher the household debt, the less inclined banks are to let people pile on new debt.
Unfortunately, the Riksbank president, Mr. Stefan Ingves, does not see this problem. Reuters again:
“Should this not be enough, we want to be very clear that we are ready to do more,” said Central bank governor Stefan Ingves. “If more is needed, we are ready to make monetary policy even more expansionary.” The central bank said this would mean further repo-rate cuts, pushing out future rate hikes and increasing the purchases of government bonds or loans to companies via banks.
As the Reuters story also explains, the Riksbank is ready to move into debt monetization – unthinkable only a year ago:
The Riksbank said it would “soon” make purchases of nominal government bonds with maturities from 1 year up to around 5 years for a sum of 10 billion Swedish crowns ($1.17 billion). But with the ECB printing 60 billion euros a month in new money the Riksbank’s much more limited program may have little effect on bond yields – already at record lows. “In terms of GDP, the mini-QE program amounts to about 0.25 percent,” banking group Morgan Stanley said in a note. “Therefore, this measure should be seen more as a signal that the Riksbank is ready to do more and remain dovish for the foreseeable time.”
In other words, here again the marginal payoff is going to be small. The only exception would be if the Swedish government decides to throw out its balanced-budget rules and start a major spending drive funded by the Riksbank. This seems unthinkable today – just like negative interest rates and a QE program seemed unthinkable a year ago.
Quantitative Easing is not a recession remedy. It is a defensive monetary strategy. So is the negative interest rate. Together, these two measures declare that a government and its central bank has reached the end of the road in trying to get their economy moving again. The big problem for Europe, Sweden included, is that they have come to this point almost seven years after the Great Recession started. With a recovery being half-a-decade overdue, with tapped-out monetary policy and fiscal policies restrained by ill-designed balanced-budget measures, Europe is firmly planted on the road straight into industrial poverty.
Sweden, with its imbalanced real estate market and very deeply indebted households, is on the same road, only with a more volatile ride.
Only a couple of days after the European Central Bank raised white flag and finally gave up its attempts at defending the euro as a strong, global currency, Greek voters drove their own dagger through the heart of the euro. Reports The Telegraph:
Greece set itself on a collision course with the rest of Europe on Sunday night after handing a stunning general election victory to a far-Left party that has pledged to reject austerity and cancel the country’s billions of pounds in debt. In a resounding rebuff to the country’s loss of financial sovereignty, With 92 per cent of the vote counted, Greeks gave Syriza 36.3 percent of the vote – 8.5 points more than conservative New Democracy party of Prime Minister Antonis Samaras.
That is about six percent more than most polls predicted. But even worse than their voter share is how the parliamentary system distributes mandates. The Telegraph again:
It means they will be able to send between 149 and 151 MPs to the 300-seat parliament, putting them tantalisingly close to an outright majority. The final result was too close to call – if they win 150 seats or fewer, they will have to form a coalition with one of several minor parties. … Syriza is now likely to become the first anti-austerity party in Europe to form a government. … The election victory threatens renewed turmoil in global markets and throws Greece’s continued membership of the euro zone into question. All eyes will be on the opening of world financial markets on Monday, although fears of a “Grexit” – Greece having to leave the euro – and a potential collapse of the currency has been less fraught than during Greece’s last general election in 2012.
It does not quite work that way. The euro is under compounded pressure from many different elements, one being the Greek economic crisis. The actions by the ECB themselves have done at least as much to undermine the euro: its pledge last year to buy all treasury bonds from euro-zone governments that the market wanted to sell was a de facto promise to monetize euro-denominated government debt. The EU constitution, in particular its Stability and Growth Pact, explicitly forbids debt and deficit monetization. By so blatantly violating the constitution, the ECB undermined its own credibility.
Now the ECB has announced that in addition to debt monetization, it will monetize new deficit. That was the essence of the message this past Thursday. The anti-constitutionality of its own policies was thereby solidified; when the Federal Reserve ran its multi-year Quantitative Easing program it never violated anything other than sound economic principles. If the ECB so readily violates the Stability and Growth Pact, then who is to say it won’t violate any other of its firmly declared policy goals? When euro-zone inflation eventually climbs back to two percent – the ECB’s target value – how can global investors trust the ECB to then turn on anti-inflationary policies?
Part of the reason for the Stability and Growth Pact was that the architects of the European Union wanted to avoid runaway monetary policy, a phenomenon Europeans were all too familiar with from the 1960s and ’70s. Debt and deficit monetization is a safe way to such runaway money printing. What reasons do we have, now, to believe that the ECB will stick to its anti-inflationary pledge when the two-percent inflation day comes?
This long-winded explanation is needed as a background to the effects that the Syriza victory may have on the euro. I am the first to conclude that those effects will be clearly and unequivocally negative, but as a stand-alone problem for the ECB the Greek hard-left turn is not enough. In a manner of speaking, the ECB is jeopardizing the future of the euro by having weakened the currency with reckless monetary expansionism to the point where a single member-state election can throw the future of the entire currency union into doubt.
Exactly how the end of the euro will play out remains to be seen. What we do know, though, is that Thursday’s deficit-monetization announcement and the Greek election victory together put the euro under lethal pressure. The deficit-monetization pledge is effectively a blank check to countries like Greece to go back to the spend-to-the-end heydays. Since the ECB now believes that more deficit spending is good for the economy, it has handed Syriza an outstanding argument for abandoning the so-deeply hated austerity policies that the ECB, the EU and the IMF have imposed on the country. The Telegraph again:
[Syriza], a motley collection of communists, Maoists and socialists, wants to roll back five years of austerity policies and cancel a large part of Greece’s 320 billion euro debt, which at more than 175 per cent of GDP is the world’s second highest proportional to the size of the economy after Japan. … If they fulfil the threats, Greece’s membership of the euro zone could be in peril. Mr Tsipras has toned down the anti-euro rhetoric he used during Greece’s last election in 2012 and now insists he wants Greece to stay in the euro zone. Austerity policies imposed by the EU and International Monetary Fund have produced deep suffering, with the economy contracting by a quarter, youth unemployment rising to 50 per cent and 200,000 Greeks leaving the country.
Youth unemployment was up to 60 percent at the very depth of the depression. Just a detail. The Telegraph concludes by noting that:
Mr Tsipras has pledged to reverse many of the reforms that the hated “troika” of the EU, IMF and European Central Bank have imposed, including privatisations of state assets, cuts to pensions and a reduction of the minimum wage. But the creditors have insisted they will hold Greece to account and expect it to stick to its austerity programmes, heralding a potentially explosive showdown.
Again, with the ECB’s own Quantitative Easing program it becomes politically and logically impossible for the Bank and its two “troika” partners to maintain that Greece should continue with austerity. You cannot laud government deficit spending with one side of your mouth while criticizing it with the other.
As a strictly macroeconomic event, the ECB’s capitulation on austerity is not bad for Greece. The policies were not designed to lift the economy out of the ditch. They were designed to make big government more affordable to a shrinking private-sector economy. However, a return to government spending on credit is probably the only policy strategy that could possibly have even worse long-term effects than statist austerity.
Unfortunately, it looks like that is exactly where Greece is heading. Syriza’s “vision” of reversing years of welfare-state spending cuts is getting a lot of support from various corners of Europe’s punditry scene. For example, in an opinion piece at Euractiv.com, Marianna Fotaki, professor of business ethics at University of Warwick, England, claims that the Syriza victory gives Europe a chance to “rediscover its social responsibility”:
Greece’s entire economy accounts for three per cent of the eurozone’s output, but its national debt totals €360 billion or 175 per cent of the country’s GDP and poses a continuous threat to its survival. While the crippling debt cannot realistically be paid back in full, the troika of the EU, European Central Bank, and IMF insist that the drastic cuts in public spending must continue. But if Syriza is successful – as the polls suggest – it promises to renegotiate the terms of the bailout and ask for substantial debt forgiveness, which could change the terms of the debate about the future of the European project.
As I explained recently, so called “debt forgiveness” means that private-sector investors lose the same amount of money. The banks that received such generous bailouts earlier in the Great Recession had made substantial investments in Greek government debt. Would Professor Fotaki like to see those same banks lose even more money? With the new bank-rescue feature introduced as the Cyprus Bank Heist, such losses would lead to confiscation of the savings that regular families have deposited in their savings accounts.
Would professor Fotaki consider that that to be an ethically acceptable consequence of her desired Greek debt “forgiveness”?
Professor Fotaki then goes on a long tirade to make the case for more income redistribution within the euro zone:
The immense social cost of the austerity policies demanded by the troika has put in question the political and social objectives of an ‘ever closer union’ proclaimed in the EU founding documents. … Since the economic crisis of 2007 … GDP per capita and gross disposable household incomes have declined across the EU and have not yet returned to their pre-crisis levels in many countries. Unemployment is at record high levels, with Greece and Spain topping the numbers of long-term unemployed youth. There are also deep inequalities within the eurozone. Strong economies that are major exporters have benefitted from free trade, and the fixed exchange rate mechanism protecting their goods from price fluctuations. But the euro has hurt the least competitive economies by depriving them of a currency flexibility that could have been used to respond to the crisis. Without substantial transfers between weaker and stronger economies, which accounts for only 1.13 per cent of the EU’s budget at present, there is no effective mechanism for risk sharing among the member states and for addressing the consequences of the crisis in the eurozone.
In other words, Europe’s welfare statists will continue to blame the common currency for the consequences of statist austerity. But while professor Fotaki does have a point that the euro zone is not nearly an optimal currency area, the problems that she blames on the euro zone are not the fault of the common currency. Big government is a problem wherever it exists; in the case of the euro zone, big government has caused substantial deficits that, in turn, the European political leadership did not want to accept – and the European constitution did not allow. To battle those deficits the EU, the ECB and the IMF imposed harsh austerity policies on Greece among several other countries. But countries can subject themselves to those policies without being part of a currency union: Denmark in the 1980s is one example, Sweden in the ’90s another. (I have an entire chapter on the Swedish ’90s crisis in my book Industrial Poverty.) The problem is the structurally unaffordable welfare state, not the currency union.
Professor Fotaki again:
The member states that benefitted from the common currency should lead in offering meaningful support, rather than decimating their weaker members in a time of crisis by forcing austerity measures upon them. This is not denying the responsibility for reckless borrowing resting with the successive Greek governments and their supporters. However, the logic of a collective punishment of the most vulnerable groups of the population, must be rejected.
What seems to be so difficult to understand here is that austerity, as designed for Greece, was not aimed at terminating the programs that those vulnerable groups life off. It was designed to make those programs fit a smaller tax base. If Europe’s political leaders had wanted to terminate those programs and leave the poor out to dry, they would simply have terminated the programs. But their goal was instead to make the welfare state more affordable.
It is an undeniable fact that the politicians and economists who imposed statist austerity on Greece did so without being aware of the vastly negative consequences that those policies would have for the Greek economy. For example, the IMF grossly miscalculated the contractionary effects of austerity on the Greek economy, a miscalculation their chief economist Olivier Blanchard – the honorable man and scholar he is – has since explained and taken responsibility for.
Nevertheless, the macroeconomic miscalculations and misunderstandings that have surrounded statist austerity since 2010 (when it was first imposed on Greece) do not change the fact that the goal of said austerity policies was to reduce the size of government to fit a smaller economy. That was a disastrous intention, as shown by experience from the Great Recession – but it was nevertheless their goal. However, as professor Fotaki demonstrates with her own rhetoric, this point is lost on the welfare statists whose only intention now is to restore the welfare state to its pre-crisis glory:
The old poor and the rapidly growing new poor comprise significant sections of Greek society: 20 per cent of children live in poverty, while Greece’s unemployment rate has topped 20 per cent for four consecutive years now and reached almost 27 per cent in 2013. With youth unemployment above 50 per cent, many well-educated people have left the country. There is no access to free health care and the weak social safety net from before the crisis has all but disappeared. The dramatic welfare retrenchment combined with unemployment has led to austerity induced suicides and people searching for food in garbage cans in cities.
There is nothing wrong factually in this. The Greek people have suffered enormously under the heavy hand of austerity, simply because the policies that aim to save the welfare state for them also move the goal post: higher taxes and spending cuts drain the private sector of money, shrinking the very tax base that statist austerity tries to match the welfare state with.
The problem is in what the welfare statists want to do about the present situation. What will be accomplished by increasing entitlement spending again? Greek taxpayers certainly cannot afford it. Is Greece going to get back to deficit-funded spending again? Professor Fotaki gives us a clue to her answer in the opening of her article: debt forgiveness. She wants Greece to unilaterally write down its debt and for creditors to accept the write-down without protest.
The meaning of this is clear. Greece should be able to restore its welfare state to even more unaffordable levels without the constraints and restrictions imposed by economic reality. This is a passioned plea for a new debt crisis: who will lend money to a government that will unilaterally write down its debt whenever it feels it cannot pay back what it owes?
This kind of rhetoric from the emboldened European left rings of the same contempt for free-market Capitalism that once led to the creation of the modern welfare state. The welfare state, in turn, brought about debt crises in many European countries during the 1980s and ’90s, in response to which the EU created its Stability and Growth Pact. But the welfare states remained and gradually eroded the solidity of the Pact. When the 2008 financial crisis hit, the European economy would have absorbed it and shrugged it off as yet another recession – just as it did in the early ’90s – had not the welfare state been there. Welfare-state created debt and deficits had already stretched the euro-zone economy thin; all it took to sink Europe into industrial poverty and permanent stagnation was a quickly unfolding recession.
Ironically, the state of stagnation has been reinforced by austerity policies that were designed in compliance with the Stability and Growth Pact; by complying with the Pact, those policies, it was said, would secure the macroeconomic future of the euro zone and keep the euro strong. Now those policies have led the ECB to a point where it has destroyed the future of its own currency.
The European Central Bank will plough €1.1 trillion into the eurozone economy in a last-ditch attempt to breath [sic] life into the European economy. At its monthly governing council on Thursday (January 22), the bank’s governing council agreed to start buying up to €60bn of government bonds from March in an unprecedented quantitative easing programme.
How is this supposed to happen? Private spending would accelerate if interest rates went down, but that will happen if and only if the interest rate on treasury bonds falls as a result of this new ECB spending program. That, in turn, can only happen if demand for treasury bonds increased enough to overcome the risk premium associated with euro-zone member states.
However, the risk premium was supposed to go away with the bond purchase program that the ECB announced last summer. Back then the bank pledged an open-ended purchase program for treasury bonds issued by troubled euro-zone countries: everyone and anyone who owned a treasury bond issued by, say, Greece would be guaranteed to get his money back by selling it to the ECB. This guarantee, then, would bring down interest rates and stimulate private-sector activity.
But this did not happen. The bond buy-back program may have had a marginally visible effect on interest rates, but it certainly was not enough to encourage any sustained upswing in private-sector activity.
When that did not work the ECB pushed bank-lending interest rates through the floor by lowering the rate on overnight bank deposits to -0.2 percent. That had no effect whatsoever on private-sector activity. So after having opened two liquidity flood gates on the European economy, without coming even close to achieving desired results, the ECB has now decided to open the third flood gate.
Well, if you try the same thing enough times over and over again, then eventually it might actually work…
Back to the EU Observer story:
The programme is open-ended, and will run until September 2016 at the earliest. Speaking at a press conference following the governing council meeting, ECB president Mario Draghi said that the bond-buying programme would remain in place “until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2%” … The Frankfurt-based bank hopes to boost inflation and drive down the value of the euro against other major currencies in a bid to make the bloc’s exports more attractive.
This is a tried-and-failed strategy. Every time a country depreciates or devalues its currency to boost exports, the main result is an increase in profits among large, dominant and already-established manufacturing businesses. Those profits, in turn, are free of charge for the businesses: all they have to do is keep manufacturing the very same products, without investments toward improved competition.
If this currency-based exports rebate is maintained long enough, the result will be a decay in productivity in exporting businesses. They have no profit-based reason to make new investments – quite the contrary. Any investments toward enhanced competitiveness will divert funds from the free-cash profits.
But what will the businesses use their cash for? Financial investments. This in turn will flood the domestic economy with even more liquidity than was already injected into it by the central bank’s aggressive monetary policy. More and more money will chase fewer and fewer profitable investments. In the meantime, little to nothing is going to happen in the real sector; the only moving part will be credit-driven consumption of durable goods like cars, and private real estate. But that will require a rapid build-up of private-sector debt, which in turn is a recipe for – yet another – future financial crisis.
Overall, as I have explained before, this QE program will notch the euro yet another inch or two toward its grave. And just to make sure there is enough certainty about where the euro is heading, the other day the the EU Observer reported that Greece may be allowed to exit its tough austerity program – without having solved its underlying macroeconomic problems:
A legal opinion by the EU top court and comments by the EU economics commissioner about the end of the bailout troika have come just days before elections in Greece, where troika-imposed austerity is a central issue. … EU economics commissioner Pierre Moscovici on Monday (19 January) … said the “troika should be replaced with a more democratically legitimate and more accountable structure based around European institutions with enhanced parliamentary control”. Moscovici added that the troika “was useful and necessary” at the height of the crisis, “but now I think we need another step.” His comments come just a week after a legal opinion by the general advocate of the European Court of Justice said that the European Central Bank should not oversee reforms of countries it helps via Outright Monetary Transactions, a bond-buying scheme coupled with structural reforms modelled on what the troika has done in bailed-out countries.
In other words, the ECB can no longer come with cash in one hand and demands for austerity in the other. It has to choose either. Since the ECB has chosen to come with money, this means an end to austerity demands.
In reality this is a carte blanche to euro-zone governments in, e.g., Greece to get back to the old days of spending. The ECB promises to buy its treasury bonds, the austerity protesters in, e.g., Syriza have in the public opinion won the argument over austerity, and the ECB is desperate to see some kind of life sign in the European economy. This is a perfect storm for a massive increase in government spending.
This is, of course, exactly the wrong recipe for the European economy. Nevertheless, this is how the game is set up. More government spending, more money printing – until the euro is in so bad shape that it collapses into junk status and goes the same way the Reichsmark did in Weimar Germany.
The cold, hard, bottom line here is that government spending, bankrolled with monetary printing presses, does not create productive economic activity. All it does is dig the economy further into the same hole into which it has been slowly sinking for the past six years.
The ECB has given up. They are not even trying to play defense anymore.
This is the beginning of the end of the euro.
How much time does the euro have left? That question was put on its edge last week when the Swiss National Bank decided it was no longer going to anchor the Swiss franc to the iceberg-bound euro ship. It was a wise decision for a number of reasons, the most compelling one being that the euro faces insurmountable challenges in the years ahead.
In fact, the Swiss decision was de facto a death spell for Europe’s currency union. More specifically, I noted that the euro…
survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.
If all the problems for the euro were tied to Greece, the currency would indeed have a future. But there are so many other challenges ahead for the common currency that nothing short of a miracle – or unprecedented political manipulation – can keep it alive through the next three years.
The biggest short-term problem – Greece aside – is the pending announcement by the ECB of its own Quantitative Easing program. Reuters reports:
The European Central Bank will announce a 600 billion euro sovereign bond buying program this week, money market traders polled by Reuters say, but they also believe this will not be enough to bring inflation up to target. In the past two months traders have consistently predicted that the ECB would undertake quantitative easing, considered the bank’s final weapon against deflation. Eighteen of 20 in Monday’s poll said the bank would announce QE on Thursday.
This highly anticipated European QE program must be viewed in its proper macroeconomic context. It is going to be very different from the American QE program. For starters, the balance between liquidity supply and liquidity demand was very different in the U.S. economy than it is in the euro zone today. After its initial plunge into the Great Recession the American economy slowly but relentlessly worked its way back to growth again. Since climbing back to growth in 2010 the U.S. GDP has grown at a rate slightly above two percent per year. This is not something to throw a party over, but it has allowed the economy to absorb much of the liquidity that the Federal Reserve has pumped into the economy.
By being able to absorb liquidity, the U.S. economy has avoided getting caught in the liquidity trap. Growth rates have been good enough to motivate businesses to increase investment-driven credit demand; households have gotten back to buying homes and automobiles (car and truck sales in 2014 were almost as good as in pre-recession 2006).
The European economy does not absorb liquidity. It is stagnant, and has been so for three years now. The ECB has pushed its bank deposit rate to -0.2 percent, in other words it is punishing banks for not lending enough money to its customers. Despite this ample supply of credit there are no signs of a recovery in the euro zone, with GDP growth having reached the one-percent rate once in three years.
In other words, the positive outlook on the future that motivates American entrepreneurs and households to absorb liquidity through credit is notably absent in the European economy. When the ECB now evidently plans to pump even more liquidity out in the economy, it appears to not understand how significant this difference is between the euro zone and the United States.
Or, to be fair, with all its highly educated economists onboard, the ECB most certainly understands what role liquidity demand plays in an economy. Its pending decision to launch a QE program appears instead to be based in open ignorance of the lack of liquidity demand.
Which leads us to ask why they would ignore it.
The answer to this question is in the declared purpose of the QE program. If it is aimed at buying treasury bonds, then the QE program clearly is not designed to re-ignite the economy, an argument otherwise used. If QE is supposed to monetize government deficits, then its purpose is really to secure the continued existence of the European welfare state. If that is the purpose, then the only safe prediction is that there will be no end to QE before the welfare state ends.
That, in turn, means the ECB would be stuck monetizing deficits for the rest of the life of the euro. Which, under such circumstances, would be a relatively short period of time…
More on this on Thursday, when the ECB is expected to announce its QE program. Stay tuned.
This week the Swiss central bank did the right thing and let go of the Swiss franc’s peg to the euro. The result was a massive appreciation of the franc, primarily vs. the euro. Though the move was not entirely unexpected, there have been a lot of speculations as to why the Swiss did it now.
The answer is not very complicated. The Swiss have grown increasingly uncomfortable with the fixed exchange rate vs. the euro, especially since the ECB:
a) pledged to buy every single treasury bond from every single euro-zone country; and
b) started pumping money out in the hot air to “stimulate spending” in the perennially stagnant euro zone.
International investors, rightly interpreting these reckless measures as the ECB playing desperate defense against the tides of macroeconomics, have taken refuge in the Swiss financial markets. To defend the peg against the euro, the Swiss National Bank (SNB) has been forced to print unhealthy amounts of new money.
There finally came a point where the SNB gave up on defending the peg. When they did they effectively acknowledged that major global financial investors have called it right: the future of the euro is limited.
More on the actual threats to the euro in a moment. First, let us take a look at a couple of interesting factoids that help explain what the SNB did this week.
In order to defend a fixed exchange rate, a central bank must constantly buy and sell its own currency on the international currency market. In this case the Swiss franc was in higher demand than the euro, which forced the SNB to sell large amounts of Swiss francs on the currency market. To do so, they had to print large amounts of money, far more than is needed to keep the Swiss economy fully liquid. Figure 1 below illustrates the excess increase in Swiss money supply over the past few years; first, though, let us note that current-price GDP has been growing virtually on par in Switzerland and the euro zone:
- Average current-price GDP growth in the euro zone, from 2008 through 2013, was 1.2 percent;
- Average current-price GDP growth in Switzerland, from 2008 through 2013, was 1.9 percent.
This is a notable difference, but not nearly enough to explain why the SNB has been printing money much more fiercely than the ECB. Figure 1 illustrates the money growth parity in Switzerland and in the euro zone – defined as M1 growth rate less current-price GDP growth:
In other words, when we subtract current-price GDP growth from M1 money supply growth, we find that the Swiss M1 growth parity has far exceeded the euro parity since 2008. Since current-price GDP growth represents growth in transactions demand for money – i.e., money to keep the economy monetized and liquid – any growth in money supply beyond current-price GDP is a sign of either of two phenomena: irresponsible funding of government debt, or a desperate attempt at keeping currency speculators and financial investors at bay.
The euro-zone’s excess M1 growth is the result of the former; the Swiss parity is the result of the latter.
During 2014 the SNB has cut down on money printing – annualized M1 growth rates per month have been less than four percent – and thereby signaled that it would, sooner or later, give up on its exchange-rate peg vs. the euro.
That has now happened. Speculators are free to rake in their currency-appreciation gains, but more importantly: investors have established their concerns about the future of the euro. Which brings us back to the limited life span of that currency. Once launched as the new gold standard of the world, the euro has fallen from the skies, badly wounded by reckless money printing.
It survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.
If Greece can get away from its debt vs. the EU and the ECB by exiting the euro, it sets a precedent for other heavily indebted countries on the southern rim of the currency area. That creates a standing threat of further destabilization of the euro – and weakens the reliability of the currency.
The second reason why the euro has a limited future lies in the ECB’s intentions to launch a formal Quantitative Easing program. De facto already in place with the treasury purchase guarantee, this formalization would involve the ECB directly in funding the issuance of new government debt (the current pledge is “only” about buying existing debt). This effectively removes any incentives that national governments have in place to keep any tabs on their borrowing.
The Stability and Growth Pact formally enforces a deficit cap of three percent of GDP, but that pact has already hit an iceberg it can’t recover from. The Pact, namely, bans euro zone countries from bailing out each other – something the Germans violated years ago by helping the EU and the ECB to bail out Spain, Greece and Portugal – and it also prevents the ECB from, yes, Quantitative Easing.
With two of the three pillars of the Pact already destroyed, what reasons do euro-zone governments have to abide by the third pillar, especially if the ECB is going to bankroll all the debt those governments may want to issue?
The third reason for a limited euro future is the French 2017 presidential election. If Marine Le Pen wins, she will pull France out of the currency union. With the second largest economy exiting there is no longer a reason for anyone else to stay in.
Switzerland once again serves as a safe haven for global investors. But the end of QE here in the United States, together with our slow but steady recovery, allows the dollar to shoulder some of that burden. The more the euro shakes and rattles, the stronger the dollar will become.
It is basically a done deal that the euro will end. All we can hope for is that it will be a peaceful exit under stable, predictable circumstances.
On Monday, in an analysis of the ECB’s declared intentions to monetize government deficits and the apparent desire to get the wheels going again in the European economy, I wrote that:
Unless the ECB is planning to buy bonds directly from European consumers, there is no direct connection between Draghi’s bond purchases and consumer spending. If he is hoping to depress interest rates even further and thereby stimulate consumption, then he has very little to play with. In most euro-zone countries interest rates are plunging toward zero – credit is practically available for free.
My comment about consumers was a bit tongue-in-cheek; it should be apparent to everyone, I thought, that handing out cash to consumers is not the way to go if you want more growth, more jobs and more prosperity.
Apparently, I had missed out on just how desperate – or economically ignorant – well-educated people can get. Alas, from Der Spiegel:
It sounds at first like a crazy thought experiment: One morning, every resident of the euro zone comes home to find a check in their mailbox worth over €500 euros ($597) and possibly as much as €3,000. A gift, just like that, sent by the European Central Bank (ECB) in Frankfurt. The scenario is less absurd than it may sound. Indeed, many serious academics and financial experts are demanding exactly that. They want ECB chief Mario Draghi to fire up the printing presses and hand out money directly to the people.
This is being done on a daily basis. Tens of millions of working-age Europeans receive cash directly from government through all sorts of cash entitlements. In 2012 the governments of the 28 EU states handed out 2.37 trillion euros in cash benefits to its citizens. That was an increase of 288 billion euros, or 12.1 percent, over 2008.
In Spain the increase was 15.8 percent, while the economy was in complete tailspin. Greek cash entitlement handouts grew by 11.7 percent; during the same time period the Greek economy shrank by one fifth in real terms.
What some thinkers in Europe are now proposing is, for all intents and purposes, the same kind of cash entitlement program, only with a short-cut administration process: instead of governments borrowing the money from the ECB and then handing it out as entitlements, the ECB should simply send the checks directly to people.
It has not worked when done the traditional way; but shame on those who give up on a hopeless idea – maybe if we print just a little bit more money, and send it to just a little bit more people, then all of a sudden the free cash won’t have the same work-discouraging effect it currently has. If we just churn out a bit more newly printed money, we will find that sweet spot when people start spending like mad dogs.
Back to Der Spiegel:
Currently, the inflation rate is barely above zero and fears of a horror deflation scenario of the kind seen during the Great Depression in the United States are haunting the euro zone. … In this desperate situation, an increasing number of economists and finance professionals are promoting the concept of “helicopter money,” tantamount to dispersing cash across the country by way of helicopter. The idea, which even Nobel Prize-winning economist Milton Friedman once found attractive, has triggered ferocious debates between central bank officials in Europe and academics.
In addition to the fact that proponents of this ludicrous idea won’t learn from existing examples, there is also the tiny little nagging thing called the Stability and Growth Pact – Europe’s constitutional debt and deficit control mechanism. The Pact consists of three parts:
1. Government debt cannot exceed 60 percent of GDP and government deficit cannot exceed three percent of GDP;
2. Member states cannot bail out each other in times of deep deficits; and
3. The ECB is banned from monetizing debt and deficits.
For a long time, member states have almost made a habit out of breaking the first rule. In recent years that has led to intervention from the EU, the ECB and the IMF, also known as the Troika, which has imposed serious austerity programs on those countries. The effect has, at best, been temporary and minor.
Germany broke the second rule when it participated in a bailout of Greece, and the ECB has been stretching the third rule time and time again by its participation in member-state bailouts. If this cash entitlement program goes into effect, it will drive a dagger through the heart of the last, remaining piece of the Stability and Growth Pact.
Der Spiegel is not too concerned with the consequences of the Pact falling apart. Instead, their article centers in on the fight against deflation, a battle that the ECB is not winning:
Draghi and his fellow central bank leaders have exhausted all traditional means for combatting deflation. The failure of these efforts can be easily explained. Thus far, central banks have primarily provided funding to financial institutions. The ECB provided banks with loans at low interest rates or purchased risky securities from them in the hope that they would in turn issue more loans to companies and consumers. The problem is that many households and firms are so far in debt already that they are eschewing any new credit, meaning the money isn’t ultimately making its way to the real economy as hoped.
And the bright minds at the ECB headquarters in Frankfurt did not realize this before they bing lending to banks? Of course they did. They just refused to see the causality between a recession, high household debt and the inability of said households to afford more debt.
Somehow they must have thought that if only you print money fast enough, credit scores won’t matter.
Anyway. Back to the helicopter cash idea and its prominent backers in the highly sophisticated world of advanced economic thinking:
In response to this development, Sylvain Broyer, the chief European economist for French investment bank Natixis, says, “It would make much more sense to take the money the ECB wants to deploy in the fight against deflation and distribute it directly to the people.” Draghi has calculated expenditures of a trillion euros for his emergency program, funds that would be sufficient to provide each euro zone citizen with a gift of around €3,000. Daniel Stelter, founder of the Berlin-based think tank Beyond the Obvious and a former corporate consultant at Boston Consulting, has even called for giving €5,000 to €10,000 to each citizen.
If this is such a good idea, why stop there? Why not crank it up to 50,000 euros? A hundred grand? What is keeping them back?
As an addition to the magnanimous disregard for basic economic theory that is fueling the monetary helicopter:
Many academics have based their calculations on experiences in the United States, where the government has in the past provided cash gifts to taxpayers in the form of rebates in order to shore up the economy.
It is one thing to let people keep more of what they have already earned. It is an entirely different thing to give them what they have not earned. When people get a tax refund they have already been productive, they have already participated in the production of total output in the economy. When people are given a handout they have not earned, they do not participate in that same production process, partially or entirely.
Cash handouts discourage workforce participation. It does not matter if it is a one-time event or a permanent entitlement program: the effect is the same, differing only in how long it lasts. When people reduce their workforce participation they increase their demand for other entitlements as well. That effect is small for temporary cash handouts, but consider what will happen in low-income families if, as a pundit quoted above suggested, the ECB gave away 5,000 or 10,000 euros per resident. A family of four would suddenly have 20-40,000 in extra cash.
How likely is it that both parents in that family will continue to work for the next year, when they just got more cash than one of them earns in a year (after tax)?
More cash in consumer hands and less workforce participation is a recipe for rising prices. Which, one should note, is just the intention behind this program. European economists and politicians are paralyzed with fear over the imminent threat of deflation. They will do whatever it takes to get inflation up to the two percent where the ECB would like it to be.
The problem is that if they succeed in causing inflation, it is going to be a rapid spike, i.e., an upward adjustment of prices very early in the spending cycle that the ECB would stimulate with its cash entitlement program. Retailers and manufacturers, squeezed by seven years of economic stagnation, will be quick to raise prices when they see a reason to do so. The price jump will eat up a large share of the consumption stimulus that helicopter proponents expect. As a result, the effect on jobs will be modest, if even visible.
Because of the inflation bump there will not be any lasting effect of this stimulus. It will be a blip on the GDP radar. The risk, however, is that the higher prices linger, thus putting pressure on money wages across Europe. It probably would not be a serious issue, but it would most likely eradicate any remaining stimulative effects of the helicopter entitlement program.
In other words, it is hard to find reliable transmission mechanisms to take the European economy from where it is today to a recovery simply by doing a one-time cash carpet bombing of the economy.
When the euro was introduced more than 15 years ago it was marketed as the rock-solid currency that would beat the sterling, the U.S. dollar and the Swiss franc as the world’s safe haven for investors.
Part of the foundation for that ambitious, but not unattainable, goal was the convergence criteria that were supposed to align fiscal policy in all euro-zone countries. Those criteria, which went into effect in 1993, were elevated to constitutional status and still guide fiscal policy in the form of the Stability and Growth Pact. One of the three pillars of the pact was a ban on deficit monetization: the European Central Bank was not allowed to print money to buy up treasury bonds.
During the Great Recession the first two pillars of the Pact have crumbled; now the third one is about to fall apart as well. From the EU Observer:
The euro has begun 2015 at its lowest level in more than eight years, as markets expect the European Central Bank to present plans to buy government bonds in the coming weeks. The single currency was trading at $1.19 on Monday (5 January), its lowest rate since 2006, after ECB president Mario Draghi gave an interview stating that the bank was preparing a programme to buy up government securities in its latest bid to stimulate greater consumer demand and avoid deflation.
Unless the ECB is planning to buy bonds directly from European consumers, there is no direct connection between Draghi’s bond purchases and consumer spending. If he is hoping to depress interest rates even further and thereby stimulate consumption, then he has very little to play with. In most euro-zone countries interest rates are plunging toward zero – credit is practically available for free.
The problem is not lack of liquidity. The problem is lack of faith in the future. More on that in a moment. Now back to the EU Observer:
Speaking to German daily Handelsblatt on Friday (2 January), Draghi said the ECB was preparing to expand its stimulus programmes beyond offering cheap loans to banks and buying private sector bonds. “We are in technical preparations to adjust the size, speed and compositions of our measures in early 2015,” said Draghi, who will convene the next meeting of the bank’s Governing Council, where the support of a majority of its 25 members would be needed for a decision to be taken, on 22 January.
That will be four days before the Greek elections, which could bring the euro-secessionist Syriza to power. Syriza is a leftist hard-liner party with Venezuela’s defunct president Hugo Chavez as their political and economic role model. They would not think twice of reintroducing the drachma if they had enough political clout to do it.
By promising to buy up government bonds, the ECB could make a direct appeal to Greek voters – or at least to an incoming Syriza prime minister – that the ECB will buy all their government debt if only they choose to stay in the currency union. That, in turn, will basically give a new Syriza government the bargaining chip they need vs. Brussels to end austerity and return to the spending-as-usual policies that reigned before the Great Depression.
Precisely the situation the Stability and Growth Pact was supposed to prevent.
And again, as always, there is the change in tone among forecasters – the same kind of change that has become so frequent in recent years:
Draghi added that the risk of negative inflation had increased … Eurostat’s monthly inflation data to be published on Wednesday is likely to show that prices fell by 0.1 percent in December, the first decline since 2009. … Market analysts are forecasting another difficult year for the single currency bloc, predicting that the euro will continue to weaken against the dollar over the course of 2015, as a result of a combination of very low inflation and weak economic performance. … The eurozone economy is forecast to have grown by a mere 0.8 percent in 2014, and to grow by a meagre 1.2 percent in 2015, well below the US.
Unless there is a radical change in fiscal and welfare-state policies across the euro zone, its GDP won’t even grow by one percent for 2015.
A bond-buying program by the ECB won’t change that. All it will do is allow governments to return to deficit spending, which is not a desirable alternative to the austerity policies of the past few years. Europe needs structural reforms in the direction of free markets, limited government, low taxes and cheap energy. Nothing else will help.