European Central Bank President Draws Line in Sand

European Central Bank president Mario Draghi announced on Thursday that he will not buy additional Italian and Spanish government bonds to help those countries reduce their borrowing costs in financial markets.

Draghi was under pressure from peripheral central bank members to start another bond buying operation but more hawkish members in Finland, Germany and the Netherlands had indicated ahead of his press conference on Thursday that they were opposed to such a move.

Although Draghi’s remarks left the door open to future bond purchases in coordination with the European bailout fund, he nevertheless drew a line in the sand when he insisted that “the ECB cannot replace governments.” Countries that suffer under high borrowing costs “need to go to the EFSF” first he said: the European Financial Stability Facility. Member states must unanimously agree for the EFSF to distribute financial aid. Read more “European Central Bank President Draws Line in Sand”

European Central Bank Signals Willingness to Intervene

The oscillations of the European debt crises have become quite familiar to those observing it. A country or national bank suffers from a negative spiral of debt and fading confidence. This is followed by a new nudge in the direction of deeper integration, or a bailout package is announced. A northern country which is fiscally sound then makes a controversial statement of refusing to cooperate on the terms proposed. This process muddles on until a new country or institution is in a dire situation. Like last year, summer holiday season generates the greatest divide between the political process and the factors that affect the crisis.

Quite apart from this has been the European Central Bank. For this reason, Mario Draghi, its president, recently caused a stir that reverberated far from the usual central bank watchers. Read more “European Central Bank Signals Willingness to Intervene”

European Banking Union Step Toward “Transfer Union”

A sunny day in Frankfurt, Germany, January 17, 2011
A sunny day in Frankfurt, Germany, January 17, 2011 (Flickr/Aeror)

In many European countries, two important but ailing institutions are currently interlinked: sovereign states and national banks. The interdependency between them explains in large measure why the continent’s leaders are contemplating a banking union.

A national bank tends to unofficially support its sovereign by buying government debt. An ailing financial system can by itself generate a large negative shock to the economy due to its function in allocating resources. This is especially true in Europe as it depends greatly on its banks for this function. Large, systematically important banks tend to be implicitly backed by their sovereigns. When either experiences considerable stress, the other suffers similarly.

The direction of causality is not always the same. In Ireland, a dysfunctional financial sector added too much debt to the sovereign when Dublin pledged to prop up its banks. In Greece, the amount of government debt generated a crisis which spread to its, and neighboring, financial systems.

When Mario Draghi decided in December of last year to provide an unlimited credit window to banks, it proved not enough to permanently instil confidence. Banks that have amassed assets on their balance sheet that may not look attractive remain fundamentally unstable. Indeed, given that the European Central Bank doesn’t necessarily operate as a “lender of last resort,” it has only put more strain on the balance sheets of sovereign states that are expected to save private banks from collapse. With this in mind, it was not a surprise that investors considered the €100 billion recently requested by Spain in support of its ailing banks as an addition to sovereign debt.

A banking union is seen as the next and a necessary step in “ever-closer union.” In view of all the other options that have been debated, most prominently eurobonds, the fact that a banking union is seen as the least worst compromise is telling.

The nature of eurobonds is comparatively simple and it is difficult to mask the fact that some countries would benefit from the fiscal discipline of others. A banking union is indirect and adds layers of complexity to the bailout process. Like the covered bond purchases of the European Central Bank during the worst of the crisis or more recent interventions, the direction of funds and who provides them is not obvious.

A European banking union, governed by the European Central Bank, would seek to correct two pressing issues. First, as deliberated above, it would decouple sovereign and banks’ balance sheets. It would give power to the European Central Bank and the European Stability Mechanism to directly support banks without having to go through the sovereign of that country. A common framework for member states should be more than able to cover the balance sheets of banks that are deemed systematically important.

Second, one prominent issue and fear has been bank withdrawals in the countries that have come under the greatest pressure. A pan-European deposit insurance would reduce the outflow for banks where there is fear of a banking collapse.

In a more general sense it would also coordinate banking supervision and regulation. As the Bank for International Settlements states in its annual report (PDF):

The conclusion is hard to escape that a pan-European financial market and a pan-European central bank require a pan-European banking system. Put slightly differently, a currency union that centralizes the lender of last resort for banks must unify its banking system. Banks in Europe must become European banks.

With negotiations regarding the new framework beginning in September and the European Central Bank’s new powers coming to force beginning in 2013, there are a number of interesting aspects to pay attention to.

These changes will need to be defined and communicated for what they are — the reality of a “transfer union” will remain. In no way does a banking union and powers to directly recapitalize banks avoid this. Rather, as some banks are effectively shielded from the possibility of default, they may be induced to buy ever greater quantities of sovereign bonds.

Austerity New Normal: ECB’s Mario Draghi

Europe’s social model is obsolete and fading, according to central bank president Mario Draghi.

“You know there was a time when [economist] Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working,” he said. “That’s gone.”

In an interview with The Wall Street Journal, the Italian head of the European Central Bank suggests that austerity is the new normal on the old continent. The social democratic welfare model of lifelong employment and generous safety nets is “already gone,” he said, citing high youth unemployment figures in the eurozone’s periphery.

In Greece and Spain, half of the workers under the age of 25 are unemployed. The jobless rate in Italy and Portugal hovers around 30 percent.


Labor market reforms are essential if the highly indebted economies in the south of Europe are to recover. In Britain, Germany and other “core” nations, it is often easier for employers to dismiss and hire workers.

In Germany and the Netherlands, trade unions have also been more willing to freeze wages and accept temporary job contracts to weather the worst of the recession. Such flexibility is supposed to be copied elsewhere as eurozone countries have enacted a pact to boost competitiveness.

Fiscal consolidation

Despite the recent emphasis on enhancing growth, Draghi said Europe must remain committed to short-term fiscal consolidation.

“Backtracking on fiscal targets would elicit an immediate reaction by the market,” he warned, and make it more expensive for countries like Italy and Spain to borrow.

Draghi acknowledged that spending cuts can hurt the economy in the short term but argued that the negative effects are offset by structural reforms.

More Cheap Money Won’t Fix Our Economy

On Wednesday, the Bank of England, the Bank of Japan, the European Central Bank and the Federal Reserve announced a plan to boost liquidity in financial markets. Under the plan, private banks will have access to cheap dollars for as long as the global debt crisis rages and they aren’t borrowing from one another. Stock indices responded favorably to the news, but the plan will, at best, only provide short-term relief.

The lack of confidence in financial markets hasn’t dissipated since the Fed printed nearly $2 trillion, so why does anyone expect the latest, actually more modest central bank intervention to have any long-term effect?

Maybe they don’t and they’re just buying time (what an appropriate expression) for politicians to come up with the answer. Given their unwillingness to seriously cut spending and not just restrain the future growth of government, it’s no surprise that investors are increasingly weary of lending these people money. Even Germany, that bastion of frugality, is struggling to sell its bunds at an affordable rate.

It’s not just the Greeks and the Italians who are bankrupt — although their debts are so colossal, one wonders how any financier could have justified loaning them money in recent years. It’s the mixed economy, that contraption of public-private entanglement known as the welfare state, that has run its course. The spectacle of Portuguese mass transit workers striking because their Christmas bonuses were cut in half is ample evidence of the moral bankruptcy of the progressive fantasy that markets could be made to work “better.”

Even in the face of sovereign default, a calamity that is virtually unprecedented in modern times, there are economists, politicians and union leaders who won’t recognize that the game is up, let alone that the average public-sector worker would be told honestly by their representatives what’s at stake. It’s not just their pensions but their livelihoods that depend on the assumption that governments cannot go broke and that central bankers and politicians can stop the contagion if only they push this button or pull that lever, as if the economy were a machine that can be “kickstarted” into growth mode.

We will not have growth in the West unless and until the massive misallocations of credit and investment that have been built up in the last ten years are filtered out of the system. This can only happen if the market is left to its own devices so worthless debt can be written off and firms can fail.

It’s a somber prospect that our leaders are trying desperately to avoid, but all their efforts to contain the damage of the credit crunch have only made things worse. Cheap money got us into this mess and it’s not going to get us out. Now is the time to repent.

This story first appeared in The Daily Caller, December 3, 2011.

Euro Leaders Stumble, Central Bank Quiet Savior

European leaders on Friday failed to deliver the sort of comprehensive reform package that markets had longed for. Without Britain’s consent, the countries in the single-currency union agreed to push ahead with a fiscal compact that aims to prevent debt crises in the future but it wasn’t clear what immediate relief eurozone governments could offer banks and investors who fear for the future of Greece, Italy and Spain.

The European leaders did agree to replace their temporary bailout fund with a permanent rescue body six months ahead of schedule. The European Stability Mechanism is now set to come into force in July of next year.

Markets may be assured by the move because it should prevent a eurozone member from ever teetering on the brink of bankruptcy again as happened with Greece, Ireland and Portugal which have all had to request European financial support. The mechanism may not be powerful enough to bail out bigger euro nations like France and Italy though nor could it halt a financial meltdown if French banks, which are heavily exposed to Greek debt, require state intervention in the event that Greek bonds need to be written off despite various rescue attempts.

There is another obstacle in the way. German chancellor Angela Merkel’s coalition partners have said to oppose the very creation of the ESM. They fear permanent bailouts for the weaker eurozone nations at Germany’s expense.

Germany opposes collateralization of European sovereign debt in the form of eurobonds for the same reason. Fiscal union, however, does appear imminent if the euro area moves to enforce semi-automatic sanctions for budget profligators in the future — a German demand on Friday.

Especially in other northern member states, there is political resistance to surrendering further sovereignty to Brussels. Yet the consensus among observers is that “Europe will need to deepen economic integration and find a politically acceptable form of collateralized debt,” as Fabian Zuleeg, chief economist with the European Policy Center think tank, put it.

“Helping the IMF to increase its lending can help tide things over for the countries which struggle to access financial markets at reasonable interest rates but it will not be the end of the crisis,” he added.

The International Monetary Fund is called in to provide short-term relief to peripheral European economies with national central banks expected to loan it up to €200 billion ($270 billion) next week. It could subsequently loan the money to troubled euro nations. The IMF can condition this lending on fiscal reforms which is deemed preferable to central banks or European governments acting bilaterally without any formal conditions attached.

Ahead of the summit, European Central Bank president Mario Draghi expressed reservation about this move because it raises questions about the independence of the central banks.

Frankfurt slashed interest rates by a quarter percentage point to 1 percent and eased rules on the collateral it asks from banks to borrow from the ECB. The policy is designed to boost liquidity in financial markets. A critical move, said Zuleeg, in counteracting the downturn because European firms rely significantly on bank financing rather than equity.

The main problem, though, argued Karel Lannoo of the Center for European Policy Studies, is not a lack of money as much as a lack of confidence in Europe’s banking sector. “Before the crisis, there was ample liquidity,” he pointed out, “with low level of capital in the banking system, and much higher levels of central bank interest rates.” Increased liquidity will do little to aid Europe’s weaker economies if it is all deposited at the central bank to draw interest.

According to Detlev Schlichter, author of Paper Money Collapse, in which he advocates a return to the gold standard, those years of ample liquidity were at the root of the crisis. “After decades of constant expansion of the fiat money supply, of low interest rates and cheap credit, banks are massively overstretched and the state, everywhere, is overburdened with debt.”

Schlichter argues that economies need to contract and banks need to deleverage to return to a growth path. “Even more money printing and attempted debt monetization” will ultimately lead to an “inflationary meltdown,” he fears and it seems that markets are increasingly worried about the prospect as well.

As long as politicians insist that “this time it is different,” investors will remain wary of lending to nations that are perceived as least creditworthy and the ECB will continue to buy peripheral bonds to prevent these countries from going under — thus prolonging the current predicament until they cut spending significantly.

Draghi on Thursday announced no change in his bond purchase operation which is capped at €20 billion per week and keeping Italy and Spain on life support.

Bank Recapitalization Will Make Euro Crisis Worse

Eurozone leaders are expected to agree Wednesday night to inject more than €100 billion in the continent’s banking sector to help it cope with an imminent Greek default.

Such a “recapitalization” of Europe’s financial industry was championed by the International Monetary Fund and the United States and is welcomed by countries whose banks are excessively opposed to Greek debt, notably France. It is why President Nicolas Sarkozy likes to enable banks to tap into the European Financial Stability Facility that was set up last year to help countries, not companies, in financial distress so his fiscal challenges won’t be aggravated. German chancellor Angela Merkel would rather banks raise capital from their own governments before raiding the bailout fund.

Whatever method is chosen (probably both), it will provide temporary relief to Europe’s sovereign debt crises before making it worse.

Europe’s leaders agree that Greek debt levels have reached unsustainable heights. Its public debt is now worth 50 percent more than its entire economy and projected to growth further in the coming years as Athens struggles to rein in spending substantially. Greek debt will be “restructured,” which means that probably 60 percent won’t be paid back. European banks which have loaned to Greece could be in trouble. Even if they aren’t, other banks and investors might worry that they are so the market tanks. “Recapitalization” is designed to prevent that from happening.

In the short term, it will but several weeks from now, markets will likely start wondering whether pumping billions of euros in a financial system that’s bloated with debt is really an intelligent strategy.

Western banks have been hesitant to loan money, to each other and to businesses, since the 2008 financial panic when the investment bank Lehman Brothers collapsed. American and European central banks lowered interest rates in response, allowing banks to borrow cheaply in the absence of private-sector confidence.

The European Central Bank has been more prudent than its American counterpart, the Federal Reserve, and didn’t buy sovereign bonds, from Italy and Spain, until this summer. The Fed, by contrast, has been financing American deficit spending by printing trillions of dollars for more than two years. Both have supported banks in the expectation that they would continue to extend business loans and mortgages.

They haven’t really — not enough to stir an economic recovery anyway because they realize that the market is still full of dislocations and excesses.

If there weren’t central banks or if they hadn’t intervened, those dislocations and excesses, build up in an era of “cheap money” when financial institutions knew that they were “too big to fail,” would have been cleared out in 2008 when Lehman collapsed and threatened to sink half of Wall Street with it. Prices that did not reflect real demand, especially in housing, where government policy had encouraged people without sufficient income to apply for mortgages, would have deflated — considerably.

Default and deflation however, along with potentially huge losses in personal savings, are politically unacceptable. So instead of failing, the institutions that created the crisis are now on life support while the housing market in many Western countries, and construction with it, is stuck. Homeowners aren’t willing to lower their expectations while buyers aren’t able to purchase at the prices they charge.

Recapitalizing banks after they bought worthless Greek bonds when they should have known better isn’t just wrong; it’s not going to work. If writeoffs are also expected for Portugal and maybe Italy and Spain, investors will realize that no matter how big the EFSF is made to be, the solvent countries in the north of Europe can’t afford to compensate them for their losses indefinitely. If the ECB also turns on the printing presses (which it doesn’t want to), that will be the clarion call for investors to get out. Interest rates on peripheral bonds will skyrocket.

The political willingness to reform structurally rather than cut several billions of euros in annual spending is virtually nil in Greece and Italy. These states are already bankrupt and waiting for Germany to pull the plug. It is king in the land of the blind (or broke actually) but doesn’t have the cash on hand to bail out half of Europe. Some countries just won’t change until they’ve hit bottom. The sooner the better for the longer banks have to wait for the inevitable, they longer they won’t invest in enterprise nor loan to other banks because they don’t know which will survive the reckoning and which won’t. Recapitalization will thus make the problem worse by providing a false sense of security that cannot last.

A revised version of this article appeared at The Cobden Centre, November 1, 2011.

Italy’s Berlusconi Reneges on Austerity Promise

Italian prime minister Silvoi Berlusconi speaks at a meeting of European People's Party leaders in Brussels, March 1
Italian prime minister Silvoi Berlusconi speaks at a meeting of European People’s Party leaders in Brussels, March 1 (EPP)

The Italian cabinet reneged on a promise to implement €5 billion worth of austerity measures this week in a move that is likely to trigger further market contention and meet the disapproval of other European Union member states.

Prime Minister Silvio Berlusconi agreed to cancel a proposed wealth tax as well as cuts in local government funding under pressure from members of his own coalition in the Lega Nord party, a separatist movement that is powerful in the industrious north of Italy.

When Italy’s creditworthiness was called into question this month, Rome hastily announced additional austerity measures in order to eliminate its budget shortfall altogether a year ahead of schedule, in 2013. In exchange, the European Central Bank in Frankfurt purchased Italian sovereign bonds in an attempt to reduce the country’s borrowing costs and prevent another European debt crisis.

The Berlusconi government had previously planned up to €48 billion in spending reductions with most cuts postponed until after the parliamentary elections of 2013. It promised to accelerate some of those plans and cut billions more between now and election year but that aim seems in jeopardy.

Europe’s central bank president Jean-Claude Trichet urged Italy on Saturday to agree to a deficit reduction package soon. “It is essential that the target that was announced to diminish the deficit will be fully confirmed and implemented,” he stressed.

The ECB spent €41.6 billion buying Italian and Spanish debt last month. Italy’s foreign minister said that his government would urge the bank to continue the bond purchase operation — something Trichet and his fiscal hawks are wary of.

The Italian treasury will be put to further test this September when €60 billion in redemptions come due.

Italy’s national debt amounts to more than 120 percent of its economy and is one of the largest among developed nations. Only Greece and Japan are more heavily indebted.

The third largest economy in the eurozone, Italy is far less competitive than Germany and other countries in the north. Cronyism, corruption and rigid labor laws constitute major impediments to growth. The judiciary is more political than is the case in most of the rest of Europe, forcing companies to often settle out of court while the prevalence of bribery and organized crime perpetuates a traditional imbalance between the industrialized north and the largely agricultural south of the country. Especially in the south, a high amount of economic activity is confined to the informal sector.

Due to its sheer size, its conservative banking industry and high level of personal savings, Italy should be able to stave off the specter of default but if there is a crisis of confidence, the country’s seemingly unstable political constellation can only deepen and prolong it.

The ruling party is beleaguered by corruption and scandals and may have to cope with a leadership vacuum if Berlusconi fails to stand for reelection two years from now. The leftist opposition, formally united in a single party since 2007, is easily scattered and generally opposed to spending reductions altogether.

European Central Bank to the Rescue

Once more unto the breach, Trichet! While central bankers from the north of Europe, including Germany, were reportedly against the ECB propping up Italy and Spain with a massive bond purchase operation, the Frenchmen acted to stem Europe’s unfolding debt crisis this weekend and prevent the contagion that nearly bankrupted Greece, Ireland and Portugal from bringing down the third- and fourth largest economies of the eurozone.

The European Central Bank announced late Sunday that it would “actively implement” its bond purchase program which had been put on hold before officials resumed purchasing Irish and Portuguese debt last week. These countries received billions in bailout funds from the European Union and the International Monetary Fund when they were no longer able to borrow against an affordable rate on the market. Read more “European Central Bank to the Rescue”

Is Austerity Failing?

In his latest New York Times column, economist Paul Krugman criticizes the “pain caucus” in Europe, notably the European Central Bank (ECB), for insisting that sound money and balanced budgets will somehow fix all of the continent’s fiscal woes. Austerity, he argues, is failing and American policymakers would be ill advised to repeat it in their own country.

Krugman’s column is unfortunately so filled with mischaracterizations and outright blunders that it is difficult to purely dissect his Keynesian alternative. In fact, he doesn’t offer much of an alternative to austerity at all except to suggest “debt reduction,” which means restructuring. He has traditionally championed stimulus though and blamed the “arrogance” of Europe’s policy elite for “pushing” the continent into adopting a single currency well before it was supposedly “ready for such an experiment.” Krugman then is no fan of the euro and hasn’t ever had much respect for Europe.

The ECB, writes Krugman this week, claims “that raising interest rates and slashing government spending in the face of mass unemployment will somehow make things better instead of worse” but only half of that statement is perfectly true. Frankfurt has been urging budget cuts but kept interest rates low at the same time not to make matters worse in the highly indebted eurozone countries of the south. Austerity, moreover, is not supposed to get people back to work directly. The point is to avert sovereign bankruptcy as would have happened in Greece and possibly Ireland without European support by restoring confidence on bond markets.

Krugman characterizes this as “belief in the confidence fairy — that is, belief that slashing spending will actually create jobs, because fiscal austerity will improve private-sector confidence.” That’s more accurate although budget cuts in themselves won’t create jobs. The private sector will if it has confidence in future growth.

But, “the confidence fairy hasn’t shown up,” writes Krugman. Case in point? Greece, Portugal and Spain where unemployment remains high. He is right but also disingenuous in pretending that those countries have fully implemented austerity measures yet — while not considering the nations that have. Read more “Is Austerity Failing?”