The Tragedy of the Euro (and Who is Truly to Blame)
After years of uncertainty following the country's 2009 crisis, Greece’s corrupt government was replaced in January 2015 by a far-left government, elected because it promised the voters it would reject onerous bailout terms from Brussels. But it turned out that as far as the ECB and Brussels were concerned, Greece’s problems were to stay in Greece, and any hopes that its troubles would be shared with the Eurozone were dashed.
In effect, it appeared that the expense of rescuing a very small member of the Eurozone risked destabilizing the others. Yanis Varoufakis, the Greek finance minister, said the reason for the EU’s uncompromising approach was it was protecting the German banks from losses. As he saw it, a sensible compromise to help a member state struggling with debt had been dismissed out of hand.
Dealing with Future Financial Crises
Commentators also argued that the EU and ECB had pursued a hard line on Greece in order to persuade other member states, who were clearly in similar difficulties, not to rely upon help from the centre. This argument makes sense. But worryingly, the Greek episode also exposed the lack of any mechanism to deal with the unexpected. There had been evidence of this at the outset, when the Maastricht conditions were enacted. Lawmakers made no allowance for economic and monetary cycles in 1992, but by 1999’s joining-date there had been three destabilising crises: Russian debt, the LTCM hedge fund crisis, and the Asian financial crisis. These combined to suppress global GDP growth and undermine assumptions about the predictability of national statistics. Dealing with future crises was obviously going to be a problem, and internal ones later arrived on cue, with Ireland, Cyprus, Spain and Portugal. Then there was — and still is — Italy.
Italy’s finances have many similarities with those of pre-crisis Greece, fueled by the suppression of borrowing costs until the music stopped in the wake of Lehman. Despite voter rebellions at successive general elections, Italy’s problems are yet to descend into a Greek-style crisis, but that is the direction of travel. And Italy is far more serious than Greece because of its sheer size.
Furthermore, the era of resolving funding problems in government finances by central banks simply printing more money has ended, and global base money worldwide is contracting. Monetary expansion was how the ECB kept bond prices up and deferred unresolved problems. From this month there will be no more asset purchases, so borrowing costs for Eurozone governments are sure to rise from extremely low interest rates.
The more one considers the outlook for the Eurozone, the riskier it appears. Until purchases ceased in December, about €2,500 billion has been invested in government bonds by the ECB. In effect, the ECB has engineered a second period of rate convergence, this time almost exclusively for Eurozone governments, while ignoring commercial interests. The lesson from the first period is it will be followed by a destructive period of rate divergence when the ECB’s steps out of the market, which it now has. Commercial banks have also been supporting their national governments despite artificially low yields, in the knowledge the ECB was underwriting bond prices.
Now that the ECB’s support for bond markets has ceased, either governments collectively stop running budget deficits, or they will have to be funded by other means. They are almost certainly not going to reduce their collective demand for more funds as the Eurozone slips into recession and rates rise against them.
Commercial banks will have to come to terms with the new reality. Having seen euro-bond yields converge then diverge in the first phase of the euro’s life, we are now seeing them diverge again. And as they diverge yet more, confidence that the euro-system and the politicians at the centre have control of events will quickly erode, as they did last time
In this context, the Eurozone’s track record of non-adaptability to changing market conditions is worrying. It leaves the prices of longer-term debt somewhat adrift, lacking natural buyers without a sharp steepening of yield curves. A buyers’ strike is beginning to look best-case, which brings us to the greatest risk of all, the pressure on bank credit to contract as banks attempt to reduce their exposure to falling government bond prices in order to preserve their capital.
Eurozone banks simply cannot afford to ride out the effect of falling prices on their core capital bases. The European Banking Commission and other regulators have introduced rules that make it impossible. Assuming a developing funding crisis begins to drive up bond yields, we can be sure that Eurozone banks will find it increasingly difficult to maintain their margins over minimum Tier 1 and Tier 2 capital requirements, as well as capital conservation buffers, countercyclical capital buffers, and global systemically important institutions buffers.
The ECB If Funding Insolvent Governments
There is therefore a growing probability that the withdrawal of the ECB as a buyer of government debt will bring forward the next Eurozone banking crisis, and it has the potential to escalate rapidly. Not only has the money-bubble through the ECB’s asset purchases gone, but there is a growing risk of contraction in the quantity of bank credit available for government bonds at a time when Italy, Spain, France and other smaller states will most need to issue new debt.
The removal of national currencies in 1999 reduced the status of Eurozone states to entities that can become bankrupt in every practical sense, even if not legally. And without the ECB financing them, they will rapidly become insolvent. Taking the Eurozone as a whole, government deficits last year needed a relatively modest €70 billion or so increase in bond issuance. Assuming no deterioration in government finances, a similar level of funding could perhaps be achieved by the ECB keeping its deposit rate at minus 0.4% and relying on interest rate arbitrage plus coupon flows to create buyers willing to subscribe for very short-term government debt.
It allows no room for slippage. The signs are that the global economy is slowing, and the widening spreads on commercial loans confirms the process of central bank base money contraction is beginning to undermine business activity worldwide. At this time of the credit cycle the process of continuing debt expansion always falls entirely on the shoulders of governments and their central banks.
The emerging signs of a credit shock that will engulf public finances are everywhere. The Eurozone appears to be at the greatest systemic risk. The only way these dangers can be averted in the Eurozone is for the ECB to reinstate its asset purchase programmes to rig bond markets again. But having just stopped them, the ECB will need very good reasons to start them again. As usual, the order is crisis first QE second.
Can European Banks Survive the Next Crisis?
Following the last credit crisis, governments took over the banks’ liabilities through bailouts. Since then, bail-in legislation has been enacted in all Eurozone member states. But if they try bail-ins to save just a few banks, they will likely collapse the whole system, because nervous bank bondholders and large depositors will flee the whole Eurozone banking system, rather than risk being forced to accept worthless bank equity.
Equally, the governments of Italy, Greece, Spain, France and others cannot afford the bail-out route, because they will be unable to fund them, and for a second time lifeboats will have to be launched by the EU, ECB, and IMF. Only this time, the amounts will be far larger. It was funding failing Spanish banks that took Spain’s debt to GDP ratio from 35.6% in 2007 to 97% today. Just imagine where it goes to on the next credit crisis, and just imagine the demands on the Italians with their debt-to-GDP ratio already at 130%.
The Eurozone is now perilously on the edge of a financial and systemic abyss. The euro itself is not at fault. The institutions behind it failed to understand that converging interest rates in its first decade would lead to debilitating malinvestments, and that interest rate convergence would be followed by destructive divergence. National governments did not understand the full consequences of no longer being able to print their national currencies.