by Alasdair Macleod
When we talk about Europe
today in an economic context, we really mean the Eurozone, whose seventeen
members are the core of Europe and share a common currency, the euro. The euro
first came into existence thirteen years ago, on January 1, 1999, replacing national
currencies for eleven states; Greece joined two years later. In theory, the
idea of a common currency for European nations with common borders is logical,
and it was Canadian economist Robert Mundell's work on optimum currency areas
that provided much of the theoretical cover.
However, the concept was
flawed from the start.
The euro would have made sense if the economies of the member states had been allowed to converge -- that is, evolve -- so that they had similar characteristics. While this was the intention from the outset, the mistake was to put convergence in the hands of politicians and their economic advisers, who (if not representing socialist parties) were and still are all interventionists. This meant that they pursued their own national agendas by intervening in their respective economies while paying lip-service to the greater European ideal. Therefore, convergence was never going to happen.
The point everyone missed is
that the only way convergence could occur is if all member states relinquished
government planning and control of their individual economies, so that an
undistorted free market across national boundaries could have developed.
Instead, central planning by individual member states was the order of the day.
Control mechanisms, such as limits on government borrowing as a proportion of
GDP and permitted budget deficits, were breached with impunity, and the fines
that should have been imposed under the Stability and Growth Pact of 1997 were
never implemented. Today all Eurozone members are in breach, with the minor
exceptions of Finland, Estonia, and Luxembourg.
The naïve ambitions behind the
Maastricht Treaty were only the start of the euro-fudge. The whole point of the
euro, so far as France and the Mediterranean countries were concerned, was to
escape the monetary straitjacket of the deutschemark, with which their
individual currencies were unfavourably compared in the foreign exchange
markets. The Bundesbank, Germany’s central bank, was truly independent of
government, and operated with the single mandate of price stability, while the
other national central banks were extensions of high-spending governments. It
was to de-politicise note issuance that, based on the Bundesbank model, the
European Central Bank (ECB) was created to be independent of all governments.
Looser Standards, Easier Money
However, while the Bundesbank
was focused only on price stability, the ECB relies on a wide range of
indicators to guide monetary policy. So where the Bundesbank was
single-mindedly objective in its approach, the ECB has become variously
subjective, being able to choose its statistical indicators at will. While
the ECB is regarded by most commentators as following restrictive monetary
policies, they are considerably more expansionary than the old Bundesbank.
Anyway, the result was that
borrowing costs for France and the Mediterranean countries fell rapidly to a
significantly lower margin over Germany’s, which was taken as the “risk-free”
rate. European banks geared up their lending to benefit from the spread,
locking in a one or two percent differential between German bond yields
compared with, for example, Italian government bonds. Gearing (i.e., levering up with
further debt) this differential ten or twenty times was a no-brainer,
particularly when it was backed by the implicit guarantee of the whole system.
This was party-time for banks, and amounted to ready finance for profligate
governments, which was the underlying reason that Greece joined -- to benefit
-- two years after the start of the Eurozone.
In order to be eligible for
monetary union in the first place, the future Eurozone members had to put their
houses in order to meet the convergence criteria. For those with unacceptable
debt-to-GDP ratios, this meant shifting debt “off balance sheet,” typically by
dropping nationalised industries from the national accounts. Various other
fudges were devised to make appearances acceptable for the target year of proof
of convergence: 1997.
This means that even today, declared
government debt is only part of the whole government debt story, with
government guarantees, actual and implied, giving a far greater potential
problem than headline debt figures suggest.
The Party Kicks into High Gear
Greece was a special case, joining
the Eurozone two years after the start. She had so mismanaged her affairs
before entering the euro that membership in the Eurozone amounted to a rescue
of Greece’s finances. Interest rates for government borrowing in drachmas had
been over 20% for much of the 1990s. By 1999, when her plans to join the
Eurozone began to be discounted, Greece's short-term government debt yields had
fallen to 7.25%. By 2005 they had fallen to only 2.5%, and even 10-year
government bonds yielded less than 3.5%. At the same time, Greece’s official
central government debt rose from €83.22bn in 1999 to €175bn in 2006, rising
further to €264bn by 2010.
Bank lending was expanding
rapidly in other countries as well, particularly Ireland, Portugal, and Spain.
And it wasn’t only government: The private sectors of these latter three
countries experienced property bubbles on the back of easy credit that sooner
or later were certain to burst.
When things are booming,
politicians take the glory and revel in their supposed success. At the domestic
level, they loosen constraints on spending. They delude themselves that the
boom is the result of their economic policies, so they extend planning and
controls over the private sector at the behest of favoured pressure groups.
Most European parliaments are coalitions, whose cohesions are bought through
favours and money, corrupting the whole political system. And at the
pan-European level, boom-times also encouraged politicians to grab their share
of glory on the bigger stage by trying to outdo each other in their support of
a common European ideal. Theirs is still a world of imagined power and
uncontrolled spending. The EU budget, an expense on top of national accounts,
is seen as a source of funds for everyone to grab before the annual budget
allocations are used up. The result is that the EU budget has been unable to
pass an audit by its own auditors for the last seventeen years.
With this gravy-train in
operation, it is hardly surprising that the politicians and their favoured
appointees lost touch with economic reality. The extraordinary lack of humility
from European leaders is evidence of this, and entirely human.
Reality Intervenes
Economic conditions have now
changed, with fear of deflation replacing easy money from before the credit-crunch
and the Lehman crisis. From then onwards, banking changed from a world of
expansion, of using all devices, including off-balance sheet vehicles, and
hypothecation of collateral, to expand their lending. It was replaced with a
sudden awareness of risk, of falling property prices and over-extended
construction businesses.
This rude shock was a global
phenomenon, affecting the US and the UK as well as mainland Europe. To stop the
global banking system from going into a systemic melt-down, Sovereign states agreed
to stand behind their commercial banks, guaranteeing all deposits. In effect,
they were committed to underwriting balance sheets that totalled multiples of
their own GDPs, turning a banking crisis into a sovereign debt crisis.
This was bad enough for
countries with their own currencies, but Eurozone governments cannot support
themselves with monetary printing, control of this function having been passed
to the ECB (the exception is the TARGET settlement facility, which is described
below). So while the US and UK were able to print dollars and sterling
respectively via quantitative easing (QE), Eurozone governments were unable to
do so.
The Importance of TARGET
The reason quantitative easing
has been so useful to governments elsewhere is that it allows government
deficits to be funded without paying interest rates demanded by bond markets.
For that reason, interest rates in US dollars, pounds sterling, and Japanese
yen can be held artificially low despite government guarantees to underwrite
their banks’ liabilities. The further advantage of QE is that it provides
commercial banks themselves with liquidity to offset contracting balance
sheets. In the absence of QE, Eurozone governments cannot so easily address
their immediate financial and economic obligations, and so they face the
scrutiny of risk-averse bond investors.
Of course, central banks are
careful to de-emphasise the reasons for QE stated above. But the publicly
stated reason, which is to help kick-start an economy, is obviously relevant
where economic recovery is prevented by the actions of banks worried about
deposits walking out of the door. This problem and that of capital flight are
generally avoided in the EU periphery countries by the smoothing operations of
the national central banks, which control the cross-border settlement system
known as TARGET (an acronym for the Trans-European Automated Real-time
Gross-settlement Express Transfer System).
Money flowing, say, from
Greece to Germany is replaced by the Bank of Greece issuing euros to leave the
quantity of money in Greece unchanged, and the inflow into Germany is
neutralised by the Bundesbank withdrawing euros from circulation for the same
reason. Both trade imbalances and capital flight are accommodated by these
means, and there is therefore no net currency issuance to accommodate them. By this mechanism, local banks facing depositor
withdrawals in favour of stronger banks in other jurisdictions are kept solvent
without recourse to the ECB.
If it wasn’t for TARGET, the
ECB would have had to step in to stop banks in the periphery countries from
collapsing. Instead, TARGET has bought time by smoothing capital imbalances and
can be expected to continue to do so. The effect has been for national
central banks in the periphery nations to operate their own, hidden version of
QE, concealed from public scrutiny because it is offset by money being drained
elsewhere from the system, mostly by the Bundesbank in Germany.
Dangerous Imbalances Are Building
In the accounts of the central
banks, the withdrawal of money in Germany by the Bundesbank is balanced in this
example by a loan to the Bank of Greece, and since the Bank of Greece is
guaranteed by the Greek Government, this is an extra, hidden government debt of
which bond markets are generally unaware. Loans under TARGET by the Bundesbank
and other national central banks to the Bank of Greece at end-2011 stood at
about €100bn, which is a combination of Greece’s cumulative trade balance with
Eurozone partners and capital flight. To put this in context, Greece’s GDP
is estimated to be about €220bn, so the other national central banks are stuck
with unsecured loans on their books that amount to 45% of Greek GDP. And
remember, this does not include capital flight over the last three months, which
in all probability will have accelerated.
Other TARGET “assets” in the
system at year-end were €195bn owed by Bank of Italy (11.7% of GDP), €170bn
owed by Bank of Spain (12% of GDP), about €120bn owed by Bank of Ireland (75%
of GDP), and €55bn owed by Bank of Portugal (30% of GDP). Exposures in the form
of loans are over €500bn to the Bundesbank, and a further €370 to the
Netherlands, Luxembourg, Finland and the ECB itself.
These are serious imbalances,
particularly for the smaller countries, and without them not only would their
commercial banks have already folded, but asset prices would also be
considerably lower. While these outcomes have been avoided so far, growing
imbalances (if left unchecked) can only result in the eventual collapse of the
TARGET system.
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