EMU Debt Crisis – Where We Are and Where We Are Heading

Image of euro banknotes and coins

Photograph by M. Bartosch

In the following Schlichter File I argue that a meaningful tightening of monetary policy in the euro-area will not occur. The banking and sovereign debt crises are not resolved. As in the US, the UK and Japan, the central bank constitutes the last line of defence against public sector default and bank failure. Protecting the purchasing power of the paper currency has everywhere become a secondary goal to keeping state and banking system going. The debasement of paper money continues.


Where we are and how we got here

I am still very pessimistic on the global economic outlook. Let me explain why. The crisis and the recession are far from over. What started in 2007 has not fully played out yet. None of the key problems have been solved. What has been achieved – if we can call it an achievement – is that via massive intervention from the state and the state central banks the collapse of large parts of the financial system has been temporarily arrested. Market forces that would otherwise point towards further deleveraging, bank closures and other adjustments have been severely weakened or eliminated to convey a flimsy illusion of stability. The gullible are being successfully distracted with concurrent economic statistics that show a recovery — if only an extremely feeble one. But the underlying dislocations remain unaddressed, such as overextended balance sheets, particularly in the financial industry, excess leverage and unsustainable asset prices. The system is still unstable, unbalanced and in need of further drastic downsizing which is being obstructed by current policy. These factors can come to the fore again at any moment. They must at some stage.

Everywhere the banks are the problem. This is inevitable in an advanced paper money system. As I explain in detail in my book “Paper Money Collapse”, a system of elastic money with a lender-of-last resort central bank at its core invariably encourages fractional-reserve banking on a scale that would be unthinkable in a free-banking market with hard money.  In such a system, banks are incentivized to drastically lower their reserve ratios and to fund lending largely through money printing – or the creation of uncovered deposit money. This allows investment in the economy to exceed the amount of true voluntary savings. The result is a credit-fuelled boom that must end in a bust and a deflationary correction. We got a glimpse of the extent of the existing dislocations in 2007 and 2008 but since then policy has gone to unprecedented lengths to avoid a further cleansing of the system.

Of course, the attraction of a paper money system is precisely that it promises -falsely, as it turns out – that credit booms can always be prolonged. Credit deflation and a contraction of the aggregate balance sheet of the banking system do apparently not have to be tolerated. There is always the option of more money creation. Therefore, in this crisis, too, the direction of policy has pointed towards avoiding a credit contraction and bank failures at all cost.

The parallels between US and euro-area

The present sovereign debt crisis in Europe must be seen in this context. Many commentators seem to believe that the problems are the result of design-flaws specific to EMU, and that their solution must be found in new institutional arrangements, such as extensive transfers, fiscal coordination or larger bailout funds. This is a misconception. Developments are in fact very similar to those in the US, which already ‘enjoys’ federal structures.

In both regions, central banks keep rates extremely low and aggressively expand their balance sheets by accumulating distressed bank assets – a policy of bank bailout that expands the supply of money. Simultaneously, the respective states socialize the fall-out from the credit boom by nationalizing big financial firms, buying assets from them or providing them with capital or guarantees. I mentioned this on a couple of occasions but it bears repeating: hundreds of billions of losses are presently being hidden or socialized by this process. That some banks are repaying state aid and others report profits (and even pay handsome bonuses again) is entirely immaterial for as long as the central banks run a policy of super-low interest rates, of asset purchases and emergency financing arrangements – all intended to sustain an over-inflated banking sector. We simply do not know which banks have survived on their own strength, or what their true profitability is. Finance is not part of what is called ‘free enterprise’. In a state paper money system, banks are never fully capitalist companies but they are even further removed from a true market in the present environment of substantial and ongoing policy support. Scepticism about the true health of the financial system and its underlying resilience is fully justified.

Neither in the US nor in Europe have any of these market interventions been removed yet. The emergency mechanisms are still in place. In both locations has the socialisation of credit-losses and the drop in tax revenue led to substantial strain on fiscal balances. In the US, this has affected state and federal budgets alike. What is a sovereign debt crisis in Europe is a municipal bond crisis in the US, complete with blown-out risk premiums for weaker issuers. The risk of default, debt restructuring and bailout will continue to overhang Greece, Ireland and Portugal, and soon maybe other EMU states, but such risks equally apply to a number of U.S states, and I doubt that the established federal structure in the US, which is often touted as a model for a more integrated and ‘policy-coordinated’ federal Europe, will mean that the bailout of some of the US states will be any less chaotic and politically charged than what we are seeing in Europe right now. Bailing out states through the federal budget is far from straightforward considering that the federal government is already routinely running $1.5 to $1.6 trillion deficits – more than 10 percent of GDP. In fact, default and debt-restructuring could soon become, in my view, an imminent prospect for the U.S. federal government itself. In the US, just as in Europe, I therefore expect the central bank to play a role in keeping the individual states going.

In Europe, countries like Ireland and Spain are most affected by the credit crash as they were the biggest beneficiaries of the credit boom. Fiscal deterioration there is to a large degree the result of the socialization of bank problems. It is often stated that the Spanish state has to recapitalize its banks, which is entirely perverse, in my view. After the artificial and damaging real estate boom has ended – hopefully for good -, the banking sector should be allowed to shrink, not kept alive in its bloated state with more money from the taxpayer. The whole debate illustrates how far banking is now removed from the principles of a market economy.

Bailouts not working

Germany is not as strong as it currently appears. A very competitive manufacturing sector, a high personal savings rate and low household indebtedness are certainly structural advantages. Yet, Germany’s banking sector is equally over-bloated and shaky as that of other countries. As 2008 has starkly revealed, German bankers are up to their neck in dodgy loans, often extended abroad, and many now rely as much on support from the state or the ECB as banks elsewhere. There are – most notoriously – the German Landesbanks and other public sector banks – frequently state-protected playgrounds for politicians who, in the twilight of their political careers, have turned state bankers. Such semi-socialist arrangements invite lax risk controls and are a veritable breeding ground for corruption.

The present German government is reluctantly supporting the enlargement of the European bailout mechanism against the wishes of its own electorate, not out of any sense of pan-European solidarity, but out of concern for their own suspect banks – habitual over-lenders to the public sector.

The bailout fund will not solve any of the present problems. In principal, European governments are expected to bail themselves out. Thirty percent of the bailout fund, which has been enlarged in case the markets begin to distrust Spain or Italy, is being provided by Spain and Italy. Germany cannot provide more money without risking complete voter revolt – but also because it doesn’t have the money. The country will soon be on the hook for Euro 190 billion in the bailout fund. If it had to borrow that much, its debt-to-GDP ratio would deteriorate to way over 80 percent – the Maastricht upper limit was 60 percent. Half of German households don’t pay taxes, and more than half of the state’s revenue from income tax is provided by just the top ten percent of earners. Germany has currently the strongest growth rate in twenty years – yet it still runs a budget deficit only marginally below the Maastricht maximum of 3 percent of GDP.

Where we are heading

Bank crises morph into sovereign debt crises and then into paper money crises. The central bank – and its printing press – becomes the last line of defense against bank failure and sovereign default. The ECB has so far exhibited less enthusiasm for a role in funding the state than the US Fed, which, under the banner of ‘stimulus’ and ‘quantitative easing’, is happily in the process of acquiring about $800 billion of US Treasury securities within six months, thus funding half the country’s record annual budget deficit. The ECB has spent about $100 billion on buying distressed sovereign debt but with the political theatre in Brussels unlikely to instil confidence in the soundness of public finances, it is only a question of time, in my view, until the ECB will have to buy more.

Understandably, the public in the US and in Europe is getting anxious about the inflationary consequences of such a policy. In the US, there is now talk of an end to ‘quantitative easing’, and the ECB has strongly hinted at a rate hike in early April. However, no meaningful tightening will be forthcoming. The ECB may give the market a token rate hike or two – a lame attempt at face-keeping. But even for this, the chances are only fifty-fifty at best. Quite simply, monetary policy will continue to be dictated, not by cyclical momentum – which is weak in any case – or by inflationary pressures – which are building rapidly -, but by the financial needs of state and banks. Just over the last weekend, it was reported that the ECB is providing additional emergency liquidity to Irish banks to the tune of Euro 60 billion. Any claims that it is ready and willing to tighten the monetary screws effectively are simply not believable.

Politicians often imply in their statements that a sovereign default in Europe would threaten the very existence of the euro. This is nonsense. The euro is an irredeemable piece of paper. It is backed by – nothing. And because it is backed by nothing, the ongoing solvency of the states that issued it is immaterial. Historically, paper money systems failed not because states went bankrupt but because states did simply not want to acknowledge that they were bankrupt and thus kept printing ever more money to keep up the façade of solvency. They kept printing money to stay ‘in business’. This is now increasingly the risk for the dollar and the euro alike. (And, in fact, for other paper monies, such as pound and yen, as well.)

The weaker countries – Greece, Ireland, Portugal – cannot leave the euro and launch their own currencies. Who would want to hold a piece of paper money shamelessly issued for the sole purpose of debasement? These currencies would sell off quickly and real interest rates in these currencies would shoot up. If that had not yet bankrupted them, then this would be achieved by the weight of the legacy debt that is – of course – still denominated in rapidly appreciating euros, and not in the new depreciating national currencies. The whole thing is a complete non-starter.

Strong countries may, of course leave the euro-area but no country is strong enough at present. The German public may prefer hard money -understandably – but I don’t think that German politicians and bankers are so keen on it.

To defend the purchasing power of paper money, and thus confidence in it, tighter monetary policy would be urgently needed. If that led to sovereign defaults and bank failures – so be it. It wouldn’t be pretty but default – whether orderly or disorderly – is the only way in which the public sector – which everywhere has become a burden on the private sector – can be lastingly shrunk, and it is the only way in which the bloated banking sector can be cut in size, too.

However, my forecast for the immediate future is a different one. By the end of the year we will not have meaningfully higher policy rates in the euro area. By contrast, the ECB’s balance sheet will be larger than today and policy support for states and banks will have expanded. The debasement of paper money will continue, inflation and inflation expectations will continue to rise. The next big event to watch out for is a rise in real interest rates. Once yields begin to exhibit a more pronounced upward drift, the problems for the banks and, by extension, the public sector will be compounded. The central bankers’ dilemma will intensify.

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  1. Zog says

    I suppose breakdown will occur when trust in sovereign governments’ ability to repay debt disappears, and it does seem plausible that it is inevitable that the process will lead to this end. The big question is when; difficult to predict of course, given the large number of variables involved, but the answer would be immensely useful!

    • says

      Absolutely correct. When trust in sovereign governments disappears — that is the crucial moment. When does it happen? Very difficult to say. Every day I am surprised that this trust has not evaporated already. To future historians the present belief in the omnipotence of the state will seem as vaguely bizarre as some religious obsessions of the past appear to us today. So in a way, it could happen any day. To give you my personal forecast, I say it will happen in the next 5 years, although I am tempted to even say the next 2. In any case, something very big will happen over this time frame on this front.

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