The Road to Serfdom

(With apologies to Friedrich Hayek)

By Marshall Auerback

The markets are again in free-fall and, once again, a lazy Mediterranean profligate is to blame.  This time, it’s an Italian, rather than a Greek.  No, not Silvio Berlusconi, but his fellow countryman, Mario Draghi, the new head of the increasingly spineless European Central Bank.

At least the Alice in Wonderland quality of the markets has finally dissipated.  It was extraordinary to observe the euphoric reaction to the formation of the European Financial Stability Forum a few weeks ago, along with the “voluntary” 50% haircut on Greek debt (which has turned out to be as ‘voluntary’ as a bank teller opening up a vault and surrendering money to someone sticking a gun in his/her face).  To anybody with a modicum of understanding of modern money, it was obvious that the CDO like scam created via the EFSF would never end well and that the absence of a substantive role for the European Central Bank would prove to be its undoing. 

As far as the haircuts went, the façade of voluntarism had to be maintained in order to avoid triggering a series of credit default swaps written on Greek debt, which again highlights the feckless quality of our global regulators being hoisted on their own petard, given their reluctance to eliminate these Frankenstein-like financial innovations in the aftermath of the 2008 disaster. 

What is required is a “back to the future” approach to banking:  In the old days, a banker “hedged” his credit risk by doing (shock!) CREDIT ANALYSIS.  If the customer was deemed to be a poor credit risk, no loan was made. 

It goes back to a point we have made many times:  creditworthiness precedes credit.  You need policies designed to promote job growth, higher incomes and a corresponding ability to service debt before you can expect a borrower take on a loan or a banker to extend one.  And, as Minsky used to point out, in the old days, banking was a fundamentally optimistic activity, because the success of the lender was tied up with the success of the borrower; in other words, we didn’t have the spectacle of vampire-like squids betting against the success of their clients via instruments such as credit default swaps.

Credit default swaps themselves are to “hedging” credit exposure what nuclear weapons are to “hedging” national defence requirements.  In theory, they both sound like reasonable deterrents to mitigate disaster, but use them and everything blows up.  At least one decent by-product of the eurocrats’ incompetent handling of this national solvency disaster has been the likely discrediting of CDSs as a hedging instrument in the future.  Note that 5 year CDSs on Italian debt have not blown out to new highs today in spite of bond yields rising over 7%, because the markets are slowly but surely coming to the recognition that they are ineffective hedging instruments – although they have been very useful in terms of lining the pockets of the likes of JP Morgan and Goldman Sachs. 

Say what you will about Silvio Berlusconi (and there's LOTS one can say about the man as any reader of the NY Post can attest).  But he was right to oppose to a crude political ploy being foisted on him by the ECB, the French and Germans to accept an irrational and economically counterproductive program fiscal austerity program in exchange for “support” from the likes of the IMF.   All Berlusconi had to do was cast his eyes to the other side of the Adriatic to see the likely effect of that. The markets’ reaction to his resignation was surreal: akin to turkeys voting for Thanksgiving.   The overriding imperative in Euroland (indeed, in the entire global economy)  should be to stimulate economic growth to ensure that there are enough jobs for all who want them.

Private spending is very flat and so they need to replace it with public spending or GDP will decline further. The eurocrats seem incapable of understanding that even if the budget deficit rises in the short-run, it will always come down again as GDP grows because more people pay taxes and less people warrant government welfare support.

As for Italy itself, this is a sordid case of the Europe’s mandarins subverting yet another democracy, through crude economic blackmail.  Already one government has been destroyed this way: In the words of Fintan O’Toole of the Irish Times:

Firstly, it was made explicit that the most reckless, irresponsible and ultimately impermissible thing a government could do was to seek the consent of its own people to decisions that would shape their lives. And, indeed, even if it had gone ahead, the Greek referendum would have been largely meaningless. As one Greek MP put it, the question would have been: do you want to take your own life or to be killed? Secondly, there was open and shameless intervention by European leaders (Angela Merkel and Nicolas Sarkozy) in the internal affairs of another state. Sarkozy hailed the “courageous and responsible” stance of the main Greek opposition party – in effect a call for the replacement of the elected Greek government.

The third part of this moment of clarity was what happened in Ireland: the payment of a billion dollars to unsecured Anglo Irish Bank bondholders. Apart from its obvious obscenity, the most striking aspect of this was that, for the first time, we had a government performing an action it openly declared to be wrong. Michael Noonan wasn’t handing over these vast sums of cash from a bankrupt nation to vulture capitalist gamblers because he thought it was a good idea. He was doing it because there was a gun to his head. The threat came from the European Central Bank and it was as crude as it was brutal: give the spivs your taxpayers’ money or we’ll bring down your banking system.

Of course, this is nothing new for the EU, as any Irishman or Portuguese citizen can attest.  Vote the “wrong” way in a national referendum and the result is ignored by the eurocrats until the silly peasants realize the egregious errors of their ways and re-vote the right way.  If it takes two, or even three, referenda, so be it. Politically, the interpretation of any aspect of the Treaties relating to European governance have always been largely left in the hands of unelected bureaucrats, operating out of institutions which are devoid of any kind of democratic legitimacy.  This, in turn, has led to an increasing sense of political alienation and a corresponding move toward extremist parties hostile to any kind of political and monetary union in other parts of Europe.  Under politically charged circumstances, these extremist parties might become the mainstream.

As for Italy itself, the country runs a primary fiscal surplus. As George Soros has noted: “Italy is indebted, but it isn’t insolvent.” Its fiscal deficit to GDP ratio is 60% of the OECD average.  It is less than the euro area average.  Its ratio of non-financial private debt to GDP is very low relative to other OECD economies.  

It is not at all like Greece.  It has a vibrant tradeable goods sector.  It sells things the rest of the world wants. You introduce austerity at this juncture, and you will cause even slower economic growth, higher public debt, thereby creating the very type of Greek style national insolvency crisis that Europe is ostensibly seeking to avoid.  And then it will move to France, and ultimately to Germany itself.  No passenger is safe when the Titanic hits the iceberg.

The entire euro zone is already in severe recession (depression, in fact, is not too strong a word), yet the ECB, the Germans, the French and virtually every single policy maker in the core continue to advocate the economic equivalent of mediaeval blood-letting via ongoing fiscal austerity.  And, surprise, surprise, the public deficits continue to grow.

Here's another interesting thing:  in the 1990s, a number of countries, including Italy, engaged deliberately in transactions which had no economic justification, other than to mask their public debt levels in order to secure entry into the euro (see an excellent paper on this by Professor Gustavo Piga, “Derivatives and Public Debt Management”, which documents this practice).  Italy actively exploited ambiguity in accounting rules for swap transactions in order to mislead EU institutions, other EU national governments, and its own public as to the true size of its budget deficit. 

And Eurostat signed off on these transactions.  And who worked at the Italian Treasury at that time?  That’s right:   “Super Mario” Draghi, who was director general of the Italian Treasury from 1991-2001 when all this was going on, and then joined Goldman Sachs (2002-2005), when the privatisations came up.  Interesting that he is now the guy who has to deal with the ultimate fall-out.  Karmic justice.

Virtually everybody has lied about their figures (Spain is a notable offender today), so listening to Europe’s high priests of monetary chastity is akin to listening to someone coming out of a brothel proclaiming his continued virginity.

Is there a solution?  Of course there is. But the eurozone’s chief policy makers continue to avoid utilizing the one institution – the European Central Bank – which has the capacity to create unlimited euros, and therefore provides the only credible backstop to markets which continue to query the solvency of individual nation states within the euro zone.  They are, as Professor Paul de Grauwe suggests, like generals who refuse to go into combat fully armed (“European Summits in Ivory Towers”): 

“The generals… announce that they actually hate the whole thing and that they will limit the shooting as much as possible. Some of the generals are so upset by the prospect of going to war that they resign from the army. The remaining generals then tell the enemy that the shooting will only be temporary, and that the army will go home as soon as possible. What is the likely outcome of this war? You guessed it. Utter defeat by the enemy.

The ECB has been behaving like the generals. When it announced its programme of government bond buying it made it known to the financial markets (the enemy) that it thoroughly dislikes it and that it will discontinue it as soon as possible. Some members of the Governing Council of the ECB resigned in disgust at the prospect of having to buy bad bonds. Like the army, the ECB has overwhelming (in fact unlimited) firepower but it made it clear that it is not prepared to use the full strength of its money-creating capacity. What is the likely outcome of such a programme? You guessed it. Defeat by the financial markets.”

The ECB should, as De Grauwe suggests, be using the ecoomic equivalent of the Powell Doctrine: when a nation is engaging in war, every resource and tool should be used to achieve decisive force against the enemy, minimizing casualties and ending the conflict quickly by forcing the weaker force to capitulate.

The ECB is the monopoly supplier of currency.  They can set the price on the rates, (obviously not the supply) so if they set a level (say, Italy at 5%) why should there be a default?  Capitulating to the markets, or entering the battle half-heartedly not only ensures more economic collateral damage, but effectively emboldens the speculators by granting them a free put option on every nation in the euro zone.  They’ll line them up, one by one, starting with Greece and ending with Germany.

The ECB continues to hide behind legalisms to justify its inaction, ironic, considering the extent to which national accounting fraud has long been tolerated in the euro zone since its inception.  The notion that it cannot act as lender of last resort is disingenuous:  The ECB does have the legal mandate under its "financial stability" mandate which was provided under the Treaty of Maastricht. 

True it is fair to say that the whole Treaty of Maastricht is full of ambiguity.  The institutional policy framework within which the euro has been introduced and operates (Article 11 of Protocol on the Statute of the European System of Central Banks (ESCB) and of the European Central Bank) has several key elements.

One notable feature of the operation of the ESCB is the apparent absence of the lender of last resort facility, which is an issue raised by the WSJ today, and which Draghi uses to justify his inaction.  But it's not as clear-cut as suggested: The Protocols under which the ECB is established enables, but does not require, the ECB to act as a lender of last resort.

Proof that the ECB exploits these ambiguities when it suits them is evident in its bond buying program.  The ECB articles say it cannot buy government bonds in the primary market. And this rule was once used as an excuse not to backstop national government bonds at all.  But this changed in early 2010, when it began to buy them in the secondary market. 

The ECB also has a mandate to maintain financial stability.  It is buying government bonds in the secondary market under the financial stability mandate.  And it could continue to do so, or so one might argue that it could.  True there is now great disagreement about this within the ECB.  It has been turned over to the legal department, which itself is in disagreement, which ultimately suggests that this is a political judgement, and politics is what is driving Italy (and soon France) toward the brink.

In fact, given the 50% “voluntary” haircut imposed on holders of Greek debt, arguably the ECB is the only entity that can buy these national government bonds today.  As Warren Mosler has noted, it is hard to see how anyone with fiduciary responsibility can  buy Italian debt or any other member nation debt  after EU officials announced the plan for  50% haircuts on Greek bonds held by the private sector: 

Yes, all governments have the authority, one way or another, to confiscate an investors funds. But they don’t, and work to establish credibility that they won’t.

But now that the EU has actually announced they are going to do it, as a fiduciary you’d have to be a darn fool to support investing any client funds in any member nation debt.

The last buyer standing is and was always to be the ECB, which will now be buying most all new member nation debt as there is no alternative that includes survival of the union.

And when this happens there will be a massive relief response, as the solvency issue will be behind them, with the euro firming as well.

Of course, we will still have to deal with the reality of a major recession in Europe so long as the faith based cult of Austerians continues to dominate policy making.  Sadly, that’s unlikely to change until people are shot on the streets of Madrid or Rome.  But at the very least, let’s get this silly national solvency problem addressed once and for all in the only credible way possible.  Mario Draghi, you have the chance to redeem yourself and your country.  Don’t waste the opportunity.