Today, the Australian Treasurer will release the so-called Mid-year Economic and Fiscal Outlook (MYEFO), which will reveal that the fiscal deficit has risen on the back of slower economic growth. I will comment about that and the reactions tomorrow, probably. Today’s blog is about the Eurozone, obviously one of my favourite research topics. There was an article in the UK Independent (December 14, 2015) by British economist Simon Wren-Lewis – Who is responsible for the eurozone crisis? The simple answer: Germany. The article largely avoids the question and chooses, instead, to focus on more contemporary influences which have magnified rather than caused the crisis. The article clearly blames Germany for the crisis and exonerates Greece, Ireland and Spain. However, I have argued in the past that France is largely responsible for the mess that Europe is in economically at present and it’s responsibility goes back decades before the Eurozone was even constructed. The causa causans of the Eurozone crisis is the essential design and construction of the Economic and Monetary Union (EMU), which was never going to be capable of operating in an effective manner. Germany set in train policies that would ensure they were insulated from the wreckage that the dysfunctional system would engender. Germany ‘gamed’ a dysfunctional system for its own advantage but they didn’t create that system and in that sense they are only a causa sine qua non, rather than the essential cause.
The Article leaves a reader to consider the proposition that if Germany had not run consistent current account surpluses and had not introduced the Hartz reforms to their labour market in 2004 then the Eurozone crisis would have been short-lived at worst.
Further, the reader is induced to believe that if Germany had not frustrated the European Central Bank’s ambitions to introduce “a large-scale quantitative easing program”, which was “some six years later than similar programs in the US and UK” then things would have been decidedly better in the Eurozone now.
In addition, the Article argues that Germany also frustrated the ECB’s attempts to act as a “‘sovereign lender of last resort’, which means being prepared to by its own government’s debt if the market fails to”. Apparently, this distinguished the Eurozone from, say Britain, where the Bank of England played “a key role in reducing the risk associated with government debt” by acting as a lender of last resort.
History seems to have slipped the grasp of the author. He says that:
The ECB initially refused to play this role, leading to self-fulfilling market panics over Irish, Portuguese and Spanish government debt. The ECB changed its mind in 2012, and the debt funding crisis quickly came to an end. Despite this, German politicians have tried to declare this move illegal in the courts.
However, he fails to mention that the ECB introduced its Securities Markets Program (SMP) on May 14, 2010 and by the end of October of that year had already purchased €63.5 billion of government debt in the secondary bond markets.
The ECB accelerated its purchases at times when the difference between the yields on some Member State government bonds against the benchmark bond, the German bund (the ‘spreads’) were widening significantly.
The first large spike in purchases in May 2010 was associated with the escalation in spreads on bonds issued by Greece, Ireland, Portugal and Spain.
So Simon Wren-Lewis is incorrect in concluding that the ECB “refused to play this role” in relation to Ireland, Portugal and Spain. In May 2010 and beyond, the ECB was effectively giving these governments billions of euros by ensuring that primary bond dealers could off-load purchases in the secondary markets at favourable prices.
A second, larger round of acquisitions began in August 2011 and were mostly associated with the sharp rise in the spread on Italian government bonds, which went from 1.5 percentage points in April 2011 to a peak of 5.2 percentage points in November 2011.
The large-scale ECB buying stabilised the Italian bond spreads by the end of 2011 and by April 2014, they had fallen back to 1.77 percentage points.
Given the size and importance of the Italian economy to Europe, the ECB was clearly not going to allow the Italian spreads to rise as quickly or as far as the Greek spreads had risen.
Of course, the SMP purchases effectively allowed the relevant governments to ignore the bond markets, which meant that the size of the spreads were moot anyway.
On September 6, 2012, the SMP was formally replaced on 6 September 2012 when the ECB introduced the Outright Monetary Transactions (OMT) program. This is the ‘change of mind’ that the Independent article is referring to.
The grain of truth in the Independent article in this context is that the German Bundesbank was highly critical of the decision by the ECB.
After the SMP was launched, a number of ECB’s official members gave speeches claiming that the program was necessary to maintain ‘market function’. In other words, by placing the SMP in the realm of normal weekly central bank liquidity management operations, they were trying to disabuse any notion that they were funding government deficits.
This was to quell criticisms, from the likes of the Bundesbank and others, that the program contravened Article 123 of the EU Treaty.
In early 2011, the fiscally conservative boss of the Bundesbank, Axel Weber, who was being touted to replace Jean-Claude Trichet as head of the ECB, announced he was resigning, ostensibly in protest at the SMP and the bailouts offered to Greece and Portugal.
Another ECB Executive Board member, German Jürgen Stark, also resigned in protest over the SMP in November 2011. Stark told the Austrian daily Die Presse that the ECB was heading in the wrong direction by pushing aside the crucial no bailout clauses that provided the bedrock of the EMU.
Weber’s successor as head of the Bundesbank, Jens Weidmann, maintained the criticism, albeit in a more muted manner.
As the ECB accelerated its SMP purchases in 2011 to quell the rising bond yields on Italian government debt, Weidmann gave a speech in Berlin on November 8, 2011 – Managing macroprudential and monetary policy – a challenge for central banks – which reiterated the Bundesbank’s obsession with inflation.
One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press. In conjunction with central banks’ independence, the prohibition of monetary financing, which is set forth in Article 123 of the EU Treaty, is one of the most important achievements in central banking. Specifically for Germany, it is also a key lesson from the experience of the hyperinflation after World War I. This prohibition takes account of the fact that governments may have a short-sighted incentive to use monetary policy to finance public debt, despite the substantial risk it entails. It undermines the incentives for sound public finances, creates appetite for ever more of that sweet poison and harms the credibility of the central bank in its quest for price stability. A combination of the subsequent expansion in money supply and raised inflation expectations will ultimately translate into higher inflation.
The German ‘Angst vor der Inflation’ is very evident in that speech. But despite the German resistance, the ECB bought billions of euros worth of Eurozone government bonds.
Whatever spin one wants to put on the SMP, it was unambiguously a fiscal bailout package. Weidmann was correct in that sense.
The SMP amounted to the central bank ensuring that troubled governments could continue to function (albeit under the strain of austerity) rather than collapse into insolvency. Whether it breached Article 123 is moot but largely irrelevant.
The SMP reality was that the ECB was bailing out governments by buying their debt and eliminating the risk of insolvency.
The SMP demonstrated that the ECB was caught in a bind. It repeatedly claimed that it was not responsible for resolving the crisis but at the same time, it realised that as the currency issuer, it was the only EMU institution that had the capacity to provide resolution.
The SMP saved the Eurozone from breakup.
It is true that the most responsible strategy for Europe, given the severity of the crisis and the particular exposure of some European economies and banks, would have been for the Council to immediately suspend the SGP provisions and for the ECB to announce that it would support all necessary fiscal deficits to offset the private spending collapse.
The former decision could have been justified under the ‘exceptional and temporary’ circumstances provision of Article 126 of the TFEU relating to the EDP.
It was clear that the situation was ‘exceptional’ and with appropriate policy action would have been ‘temporary’. The Council had already demonstrated a considerable propensity to bend its own rules.
The ECB could have immediately announced a program such as the SMP whereby it promised to buy up unlimited volumes of national government debt in the secondary markets.
If the SMP had been introduced in 2008 rather than 2010 and without the conditional austerity attached, things would have been very different.
No Treaty change would have been required for either of these ad hoc arrangements to be put in place.
While obviously inconsistent with the European Groupthink, these policy responses would have saved the Eurozone from the worst.
Fiscal deficits and public debt levels would have been much higher but in return, there would have been minimal output and employment losses and private sector confidence would have returned fairly quickly. The response of the private bond markets would have been irrelevant.
So the conclusion by Simon Wren-Lewis that “Germany helped to aggravate the 2010 crisis by pressurising the ECB not to act as a lender of last resort” is in historical terms incorrect.
The fact is that the ECB did introduce the SMP, and despite its own efforts to distance the program from so-called Quantitative Easing (QE) and the ‘printing money’ connotation by ‘sterilising’ the intervention, the reality was that the SMP was virtually indistinguishable from QE.
Both strategies kept bond yields lower than otherwise by strengthening demand in the private bond markets and both provided an interest-bearing alternative to the bond holders via the standing facilities on excess reserves (offering a return on excess bank reserves).
QE added bank reserves (cash) and the relevant central bank then paid interest on the excess reserves created, whereas the ‘sterilisation’ functions associated with the SMP merely shunted the excess euro reserves created by the bond purchases into a separate ECB account, which earned interest.
So the fact that the ECB is only now openly calling its bond purchasing program QE doesn’t negate the reality that it had been conducting an equivalent program at the height of the crisis in 2010.
The Independent article correctly challenges the notion that the Eurozone crisis was “an inevitable result of the debt funding crisis that hit the eurozone periphery in 2010”. In other words, the author is rejecting the narrative that the origins of the crisis is to be found in government debt dynamics.
The author rightly points out that:
Countries like Belgium or Italy entered the crisis with debt-to-GDP ratios over 100 per cent, yet did not require Troika bailouts, whereas Ireland and Spain, which had ratios below 40 per cent, did.
The author concurs with what is becoming a popular explanation for the crisis that ” the 2010 crisis was essentially the result of excess lending to the private sectors of countries such as Ireland, Portugal and Spain, lending that often originated with banks in Germany or France”.
In other words, the crisis was a private debt crisis rather than a public debt crisis.
Simon Wren-Lewis does acknowledge, in a roundabout sort of way, that currency sovereignty is important. He noted that:
It is now well understood that the reason why economies in the eurozone, and only those economies, suffered a debt funding crisis in 2010 is that these countries did not have their own central banks.
Other capacities were also lacking:
1. Their governments did not have legislative authority over the currency issuing institution.
2. They did not have their own floating exchange rate.
3. They used a foreign currency (the euro!).
4. They issued debt in a foreign currency (the euro!).
5. They were unable to run deficits commensurate with the non-government sector spending gap as a result of the fiscal rules under the Stability and Growth Pact (SGP).
It is hard to blame Germany for all of those missing capacities. To fully understand the Eurozone crisis since 2010 we have to do understand why such a defective monetary arrangement was implemented in the first place.
That is what my current book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale is about. It is a long story that dates back in time to the efforts made in the immediate post-Second World War period to ensure a lasting peace would ensue.
The Eurozone crisis is the combination of two very powerful and destructive vices.
The first is the age-old Franco-German rivalry. A corollary to this rivalry is a disdain for the ‘Latinos’ who by geographic proximity cannot be ignored, much to the angst of those further north.
A major driving force in the early debates about European integration was France not Germany. France was caught up in its own sense of ‘exceptionalism’, which was driven, in fact, by deep inferiority as its colonial empire was collapsing.
The cultural and historical aspects of the Franco-German rivalry are permanent constraints on European progress. At some point the Gauls and the Prussians began hating each other and it is clear that the two ‘nations’ were at odds after Napoleon incorporated German-speaking areas such as the Rhineland during the First Republic.
The long-standing ‘enmity’ evolved in the post World War II period. While the rivalry was intense and open under President de Gaulle, which held back European integration, later the rivalry was expressed from the French side as a desire to neutralise German power, and the only way to do that was to create a European state where France dominated.
French politicians of various persuasions firmly believed that they could control the process of integration by setting up European-wide institutions that would not only be controlled by national governments, but, those national governments would be, in turn, dominated by French superiority.
After all, Germany was in tatters and not in a position to assert any European-wide power.
From the German side, whether anyone wants to talk about it or not, a deep and silent shame gripped the nation as a result of its actions during the 1930s and 1940s. The only source of national pride became Germany’s economic acumen, its technical and organisational skills and the discipline of its workers.
The stereotype of the ‘clever German’ arose to replace that of the ‘ugly German’. European integration became a way the German nation could win back some respect by demonstrating that it could be part of a peaceful Europe. Reunification accelerated that desire but accentuated the paranoia in the rest of Europe about the ‘German question’.
This rivalry and divergent ambitions and motivations dominated the path to monetary union over many decades. When finally Mitterand and Schmidt seemed to be working together, the motivations and cultural baggage remained as disparate as they had been when Monnet and Schuman first proposed the ‘European Project’ in the late 1940s.
The problem was that the French seriously overestimated their own capacity and created a monster, which under the guidance of Jacques Delors, became the Maastricht Treaty.
The second vice that has crippled the Eurozone is the domination of free market economics, the Groupthink, which though empirically deficient and riddled with internal theoretical inconsistencies, still rules the academy and through its graduates, the policy making sphere.
How the economics profession has been able to convince the rest of us that by ‘counting angels on a pinhead’ and then not being able to correctly sum the angels they claim to see (their so-called ‘economic models’), they have anything to say about enhancing societal well-being, is a study in itself and constitutes one of the biggest frauds of the 20th century and beyond.
All the evidence from psychology and behavioural studies tell us that the mainstream economic assumptions about human motivation and decision-making are devoid of reality.
Simon Wren-Lewis is a practitioner of New Keynesian thinking, a major stumbling block for progress in economic thought. Please read my blog – Mainstream macroeconomic fads – just a waste of time – for more discussion on this point.
But it was the rise of Monetarism, which originated out of the academy in the US, that created a ‘post national’ tension among the politicians, and cut across the old state based rivalry between the nations in Europe.
Whereas the early discussions about union placed the national state at the forefront, by the time Delors and his Committee met (in the late 1980s), the global capture by the financial elites of the policy process was well entrenched and the promotion of Monetarist economic ideology aided their agenda.
Recall that Delors excluded the national finance ministers from his panel to ensure that the Monetarist perspective would emerge quickly and not become derailed by national political hankering.
It was imperative that the supranational entities, which were created as part of the union, were consistent with this post national ideology.
That is why the fiscal role of the state was so restricted and the primacy of the depoliticised ECB elevated.
The old national rivalries have persisted but their expression has become increasingly channelled by the free market narrative, which created the monster that is the EMU.
Initially, the Germans were not in a dominant position. The French drove the process of integration and became increasingly influenced by the Monetarist thinking, which pushed them closer to the German emphasis on monetary control and fiscal thrift.
What the French didn’t appreciate was that this emphasis could not deliver effective outcomes to its own economy much less the broader European Member States, given the fact that German manufacturing and its trade capacity was superior in every way.
The French played into the German hands. If they had not become intellectually infested by Monetarism then the stand-offs that had prevented the earlier attempts at monetary integration (for example, the Werner report in 1970) from being implemented would have persisted.
The convergence among policymakers, their advisers, the bureaucracy, and the commentariat in the media to Monetarist ideas allowed the German monetary mentality to play a large role in the design of the EMU.
So the Eurozone crisis is not the fault of Germany. France drove the move to integration thinking it would dominate. It was a delusional expression of their own pathetic sense of being exceptional.
While I don’t believe Germany caused the crisis nor do I exonerate it from magnifying the consequences of the monetary system failure.
I have written about that on numerous occasions. For example, in the blogs – The German model is not workable for the Eurozone and Germany is not a model for Europe – it fails abroad and at home – I outlined why the German model is an inappropriate way for the Eurozone to proceed as it sought recovery.
I won’t repeat the arguments made in those blogs and other blogs I’ve written in a similar vein. Essentially, the latter blog cited contains a very similar discussion to that which appeared yesterday in Simon Wren-Lewis’s article. There is no accusation of plagiarism but the construction of the argument is uncannily similar – the emphasis on the Hartz changes and the divergence in unit labour costs, for example.
At present, a number of economists are attempting to revise the narrative to make it appear that my profession is not profoundly implicated in the Eurozone crisis and the GFC, more broadly.
In the last year, we are seeing several public statements acknowledging issues about the unsustainable buildup of private debt, the inflexibility of the fiscal rules in the Eurozone, and other obvious things that have been staring them in the face for years only to meet met with ideological denial.
Some of these economists even have the audacity to claim that the existing body of mainstream macroeconomic literature readily explains the crisis and prescribed the cure.
This is laughable when we think back to the dominant New Keynesian models, which didn’t even have financial sectors integrated within them.
There is also an on-going denial of the historical factors that have created the EMU and why it failed. Acknowledging those factors would be tantamount to a rejection of mainstream macroeconomic theory and practice.
It is thus convenient to black sheep Germany because its behaviour during the crisis and prior has been nothing short of reprehensible. But it was only acting within the parameters of the system that France and the other Member States eagerly embraced as a manifestation of their Monetarist ideals.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.