Sunday, September 9, 2012

The Eurozone: Draghi, debt and distress

by Michael Roberts

The decision of the European Central Bank (ECB) to buy ‘unlimited’ quantities of government bonds of the distressed EMU states of Portugal, Ireland, Spain and Italy sets the next stage in the long saga of the euro debt crisis.  But former Goldman Sachs executive and now ECB President Mario Draghi said at the end of July that he would “do what it takes” to save the euro and ensure that the likes of Spain and Italy could still borrow funds to cover their debt obligations and finance any government spending over and above revenue.

But Draghi made it clear that the ECB would only help as long as Spain and Italy formally asked for a bailout package from the Euro authorities and were thus subject to the severe fiscal conditions set by the ECB, EU and the IMF, or the so-called Troika. The ECB would only help as long as governments stuck to the task of cutting government spending, slashing services and reducing pensions and wages (‘labour reform’) in order to stabilise their debt burdens. Sr Draghi did not explain what would happen if a government agreed, then got funding and the ECB bought its bonds, but then reneged on the deal.

The ECB plan is to make what it calls Outright Monetary Transactions (OMTs), namely outright purchases of the government bonds of those already in Troika programmes (Portugal, Ireland and Greece) and any others that might sign up (Spain, Italy).  The ECB will buy the bonds in the secondary market.  It won’t buy new issues of government bonds, but instead buy existing bonds in the market that are already held by pension funds and banks.  The aim is to provide sufficient demand to drive up the prices of these bonds and so reduce the effective yield (interest rate) on them.

Yields on existing Spanish and Italian bonds have reached 6-7%, or more than triple the rate before the euro crisis began.  The high yields mean that any new bond issued by these governments must offer a similar yield to attract buyers.  And governments must issue new bonds to roll over the repayments on existing bonds that mature and also to cover new borrowing.  That is hundreds of billions of euros each year.  If the new bonds have to be sold with interest rates over 6%, the cost of borrowing will rise sharply and drive up government spending costs.  Already Greece, despite defaulting on one-third of its debt and restructuring it, is paying such a high rate of interest on new debt that interest costs are equal to 25% of all government spending.  Of course, spending on public services and welfare benefits have been crushed.

If euro governments had to keep going to the bond market and be charged ever rising interest rates for their borrowing, debt would just spiral out of control as more debt would have to be issued to cover the cost of previous debt!  Eventually, governments would be forced to default on their debt.  If that happened to big governments like Spain and Italy, that would be the end of the euro as we know it.
So the ECB has finally stepped in to try and tide over the distressed EMU governments for the next year or so, in the hope that bond markets will calm down and start buying government bonds at more reasonable rates and that eventually economic growth will return to Italy, Spain, Portugal and Greece, so that they can meet their commitments as government revenues rise sufficiently again.

Even so, the ECB’s plan is really one of smoke and mirrors.  The ECB may buy hundreds of billions of government debt, but it will not ‘print money’ to do so.  The purchases will be ‘sterilised’.  That means the ECB will then offer these bonds on loan to the banks that they have already bought them from in weekly auctions.  The banks will take them on loan because the interest on these government bonds will be higher than what they can earn leaving cash on deposit at the ECB.  And the banks have huge cash reserves built up at the ECB to lend back.

Where did they get this cash?  Well, the ECB has been providing ‘liquidity facilities’ to the banks, namely what are called Long Term Repo Operations (LTROs), over the last few years. Banks that could not borrow from other banks or elsewhere could go to the ECB and get unlimited amounts of loans for up to three years in return for any collateral like government bonds or corporate bonds or mortgages that they might have.  So the banks got a lot of dosh that they could not raise anywhere else to bolster their weak balance sheets and keep themselves solvent.  They did not lend much of this money onto the ‘real economy’ (households and companies) but simply held it at the ECB or bought their own government’s bonds.  So they have reserves of up to €800bn at the ECB.  Now the ECB can now borrow this back and use it to buy government bonds through the OMT.  Talk about a circle of money transfers!

But this does mean that the ECB now has more firepower in addition to the new permanent bailout body that the EU has agreed to set up, the European Stability Mechanism (ESM).  The ESM has €500bn to provide funds for Eurozone governments in distress under strict conditions of Troika-style fiscal probity.  The ESM has still to be ratified fully and implemented, but the ECB now can add firepower of up to another $800bn – not quite ‘limitless’, but more than enough to cover the funding needs for years ahead if the private sector won’t buy their bonds at reasonable prices.

The ECB may not be ‘monetising’ government debt by creating money to buy bonds.  But it is taking on huge liabilities.  If the likes of Portugal, Spain and Italy default on their debt, the ECB will be left holding worthless assets, which could write off all its available capital (€80bn) and reserves (about €400bn).  It will buy government bonds of up to three years maturity, so the risk is over a fairly long time.  And it already holds as collateral for loans to the banks very large amounts of dodgy mortgages and bonds, all of which could also default,if these governments were to default.  The remaining solvent Euro governments would have to pick up the bill.

That is what worries the German government and, in particular, the German central bank, the Bundesbank, which registered its public opposition to the Draghi plan. The Bundesbank just wants to continue with fiscal oppression through the Troika programme on distressed Eurozone governments. It sees the ECB’s purchase of bonds raising the risk of the ECB going bust and also enhancing ‘moral hazard’ i.e. where borrowers think they will always be bailed out and so renege on their fiscal commitments. The view of the other Eurozone governments is that there is no alternative to the ECB funding the likes of Spain or Italy or they will soon default and then the euro will break up.  So they have overruled the Germans.

The German ruling elite has a problem.  The German public is growing increasingly hostile to bailing out what it sees as profligate Club Med governments with taxpayers money.  And the German Constitutional Court is about to rule on whether even the agreed ESM is legal under the German constitution because it commits German taxpayers to the risk of default by other governments and the Germans can be outvoted on the ESM.  The court will probably rule that the ESM can go ahead, but it will oppose any further measures like allowing the ESM to borrow from the ECB or allowing Spain to have funds to bail out its banks without first coming under a Troika programme.

If the Draghi plan is then implemented and is not blocked by the Germans or by any courts, then it will probably provide more breathing space to keep the euro intact.  That is certainly the hope of financial markets, which jumped up on the news.  But even then, there are still lots of storm clouds ahead.  First, the Spanish government is reluctant to apply for a debt bailout because it fears that the fiscal conditions under a Troika programme will be too onerous to avoid social explosion in Spain.  Its own existing fiscal austerity measures have already caused widespread protests and loss of popular support for the Conservative government. Extra measures on top could be suicidal.  However, the Spanish are being ‘encouraged’ to make an application before the EU summit at the end of October and before Spain has huge bond redemptions (repayments) to make at the end of that month.

Then there is Greece. The Troika is back there to consider whether the Conservative-led coalition has done enough to close the shortfall on previous fiscal targets and so can meet the conditions for the next tranche of bailout funds to keep it going.  The coalition has tortuously tried to come up with ‘savings’ of around €13bn on top of all the cuts already made. The smaller parties in the coalition are reluctant to agree all the terms because they fear a backlash from the electorate and further social upheaval now that the holidays are over.

The coalition is asking the EU for two extra years to meet its deficit and debt targets, but so far the Germans are playing hardball.  And the troika is demanding even harsher austerity measures including more wage and pension cuts (already cut 40%) and a six-day week for all Greeks as normal! The Greeks already work the longest hours in Europe (see my previous post, Europe: default or devaluation?, 16 November 2011). So the Greeks face yet more cuts in living standards and public services after five years of recession and with prospect of at least another year or two of contraction in the economy. Greek capitalism was always weak, but it has been brought not just to its knees by the crisis and the Troika demands but is now flat on its back.

Ironically, the prostrate body of Greek capitalism is beginning to show flickering signs of life.  You see, if capitalism is not replaced, it can eventually recover at the expense of people’s incomes, jobs, health and even lives. ‘Internal devaluation’ (i.e. cutting domestic costs for business) is beginning to work in the distressed states. In Greece, for example, unit labor costs rose 33.7% between 2000 and 2009, while in Germany they rose just 0.6%. But this gap between German and Greek unit labor costs has already dropped to less than half the 2009 peak.  Indeed, on current trends, Greek unit labour costs will be lower than Germany’s by early 2015, as Greek wages drop by over 40% and German wages rise by 10%. Greek capitalism is becoming ‘competitive’, but taking around eight years of hell to do so!

Capitalist economies can only recover when profitability in the productive sectors is sufficiently restored.  That requires a devaluation of old and dead capital, both real and fictitious.  Debt must be ‘deleveraged’ or written off and companies must go bust and workers must lose their jobs and join the reserve army of labour.  The latest data for Greece show that this is happening. The Greek capitalist patient may eventually come out of its coma.  But the question is: will the Greek people swallow two or more years of grinding poverty and distress so that Greek capitalism can become sufficiently profitable that Greek and other European investors will start to spend there again?  And will the Troika decide before then that Greece is a lost cause?And that is the issue for the euro.  The Eurozone as a whole is in a recession and the distressed states are in a depression. The euro cannot survive the pressure of economic collapse indefinitely. The centrifugal forces that could break up the Eurozone are intensifying.  Banks in the core of Europe are not lending to the periphery and each national banking system is just buying their own government’s bonds and not each other’s.  This is graphically expressed in the deficit that the commercial banks of the distressed states have with the Eurosystem compared with the surplus the core banks have under the so-called Target 2 data.

That is why Draghi has acted despite German opposition. The time for holding the euro together is running out.  In the end, the fate of the euro will be decided by the Germans, not Greece.  If the German leaders, encouraged by France, continue to reckon that the euro is worth saving compared to the cost of breaking up (and that is considerable – see my previous post, No vacation for the euro, 24 July 2012) and going it alone (and they can convince the German people to do so), then they will go along with yet more funding to keep the euro going for a few more years.

Longer term, the euro will only survive if the European capitalist economy returns to some level of economic expansion and Europe’s leaders manage to organise a full fiscal and monetary union.  But that will probably be impossible without the democratisation of EU institutions, something strongly opposed by the current leaders of the major European nations.

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