Brussels’ plan for bad loans is a second bailout for the banks

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Barely a word has been said in the Irish media to date about an extremely important new proposal from the European Union (EU) Commission – to develop a so-called ‘secondary market’ for non-performing loans. If implemented, this package of policies will directly cause an increase in evictions and homelessness, enable the harassment of mortgage-holders by debt collectors, and generate massive new risks to financial stability.

This proposed EU Directive on credit servicers, credit purchasers and the recovery of collateral will jettison even the (extremely) limited progress the Irish state has made on regulating vulture funds.

“Credit purchasers” refers to vulture funds and securitisation institutions, “credit servicers” means debt collection agencies, and the proposal for the “recovery of collateral” is for accelerated out-of-court enforcement of loans secured by collateral – meaning banks will be able to seize their customers’ property without going through the courts.

In short, it will let the EU’s banks carry out a mass sell-off of bad loans to US vulture funds; shift almost a trillion euros of bad debt off the banks’ balance sheets into the opaque and unregulated shadow banking sector through the same instruments that caused the 2008 crisis; implement rules that mean the vultures cannot be regulated in any way within the EU and can operate across borders without any restrictions; and add nothing whatsoever to the existing level of consumer protection to borrowers and homeowners in the EU.

A toxic debt mountain

Non-performing loans (NPLs) are bank loans that are subject to late repayment or are unlikely to be repaid by the borrower. EU standards now generally require banks to classify loans as non-performing if they are more than 90 days in arrears. The ability of borrowers to pay back their loans deteriorated significantly during the financial crisis and the subsequent double-dip recession. As a result, many banks saw a build-up of NPLs on their books, particularly in the countries worst affected by the crisis.

Euro-area banks held just over €1 trillion in NPLs in 2016, the equivalent of around nine per cent of the Eurozone’s GDP, and amounting to around 6.4 per cent of total loans in the Eurozone. The level of NPLs differs dramatically across the euro area, with almost half bank loans in Greece and Cyprus classified as NPLs, and Italy, Ireland, Portugal and Slovenia all holding NPLs at rates of 10-20 per cent. While the average ratio of NPLs in the EU has decreased by more than one-third since 2014, the total volume of NPLs remains high, at around €820 billion as of December 2018.

The proposed EU Directive is touted by the Commission as having one main aim: to free up banks to lend to consumers and small businesses again by reducing the high levels of bad loans on their balance sheets.

But even a cursory glance at the lending statistics across the Eurozone and the EU demonstrate clearly that the lower level of lending by banks is not caused by a lack of willingness by banks to provide credit, but rather by a lack of demand for credit from SMEs, companies and households.

In reality the proposal has three key aims:

  • To encourage EU banks to reduce their stocks of sour loans by any means necessary so they can return to pre-crisis profitability levels and compete once more with US banks;
  • To take away the right of EU member states to place regulations and restrictions on vulture funds and debt collectors that may impede their ability to enter the EU and operate freely across borders; and
  • To give the banks and vulture funds new powers to seize their customers property if they fall behind in repayments of debt – without having to bother with the irritating process of actually claiming this collateral through a court in which the judge is legally obliged to consider the rights of the consumer.

Replicating the Irish model across the EU

The European Commission has looked at the post-crisis process in the Irish state where banks have reduced their stocks of non-performing loans significantly, decided it is a glorious success story, and resolved to replicate this process across the entire EU.

The key components of this ‘success’ story in Ireland were the creation of the National Asset Management Agency (NAMA), which used public funds to take bad loans off the balance sheets of the bailed-out Irish banks; the grovelling invitation to US vulture funds to enter the Irish market by former Finance Minister Michael Noonan; and the eagerness of the Irish banks to engage in the mass sell-off of their customers’ mortgages and loans to these debt vultures at a fraction of their value.

Following this logic of trying to replicate the Irish model across the EU, the Commission made a legislative proposal in March 2018 based on four key aspects:

  • Provisioning by banks – a Regulation to require banks to put aside their own capital to cover the loss of a bad loan;
  • A Directive on developing a secondary market for NPLs – promoting the sale of bad loans to vulture funds, and promoting securitisation;
  • The same Directive to cover debt recovery – giving banks more power to enforce the collection of collateral through out of court recovery; and
  • Non-binding guidance for Member States on how to establish a national Asset Management Company – a NAMA-style bad bank, including possibly using public funds.

In fact, the Commission has proposed that all credit agreements – i.e., even performing loan agreements in which the customer has fulfilled every obligation required of them – should be within the scope of this Directive and therefore able to be sold on to a third party.

ECB Guidance on reducing non-performing loans (2017)

The Commission proposal of March 2018 was preceded by rules issued by the ECB, which published its Guidance to banks on NPLs in March 2017, setting out the manner in which it expected banks to reduce their existing stocks of NPLs. This Guidance is non-binding but subject to a comply-or-explain type system in which supervised banks must explain deviations upon supervisory request, and in which non-compliance may trigger supervisory measures.

The Guidance only applies to the largest banks in the EU, which are supervised by the ECB’s Single Supervisory Mechanism. It states that each bank with elevated levels of NPLs is expected to develop portfolio-level reduction targets with a view to reducing the level of non-performing exposures on its balance sheet in a timely manner. The Addendum to the Guidelines calls for these banks to enact a reduction plan if their level of NPLs passes a threshold of five per cent of their overall balance sheet.

This Guidance has been used by banks in several member states – and particularly by Irish banks – to prompt and justify their mass sell-offs of mortgages to vulture funds. Irish banks constantly point the finger at the ECB when selling mortgages to vulture funds, claiming the ECB forced them to. But this is simply not true.

The ECB “has not expressed a preference for certain NPL reduction tools over others” in its non-binding Guidance, and has clearly stated that the combination of tools or strategy reduction drivers for a given bank is the responsibility of, and chosen at the discretion of, its management, which could include debt restructuring, debt forgiveness and many other measures that don’t involve vulture sales.

No doubt the ECB has applied pressure to banks to reduce their bad debt levels, but it has no legal mechanism to force banks to sell loans to vultures and it explicitly denies doing so.

Having said this, the role of the ECB has been one of consistently undermining the rights of homeowners and borrowers, to the benefit of the banks and vulture funds. Every attempt to regulate the debt vultures that we have seen in the Irish state in recent years – every draft piece of domestic legislation – has been referred to the ECB for its ‘opinion’. The ECB’s opinion always seems to be that the banks should be allowed to get rid of their bad loans by any means necessary.

The Commission’s proposed Regulation on banks covering NPL losses is similar to the ECB Guidance except it applies only to future NPLs and not the existing stock; it provides a slightly more lenient time frame for banks to set aside their own funds to cover future NPL losses; it is legally binding; and it applies to all banks and not only the largest ones that are under the direct supervision of the ECB.

In theory, the proposal for a Regulation to require banks to put aside their own capital to cover the loss of future NPLs is sensible from a financial stability point of view in that it will encourage banks to engage in more responsible lending behaviour, and reduce the likelihood of the need for public bailouts of banks in future.

The Commission’s proposal could have encouraged banks to work through future non-performing loans with their customers on a case-by-base basis; and provide concessions to their customers including extensions of repayment periods, lower interest rates, debt forgiveness or many other options.

But taken in combination with the Directive on developing a ‘secondary market’ for bad debt, in reality it instead encourages the banks to take no responsibility for their predatory lending practices and dump their toxic debt into the shadow banking sector, or worse, taxpayer-funded ‘bad banks’.

We cannot apply a one-size-fits-all reduction target that will incentivise banks to offload their loans onto the secondary market. Banks should be required to keep their NPLs on their book and to work through them with their customers by writing down, restructuring or forgiving the debt, particularly in cases of residential loans.

Wtf is securitisation?

As well as giving free rein to debt vultures, this Directive also aims to promote the use of securitisation vehicles to ‘refinance’ bad loans, or to move this bad debt off the banks’ balance sheets and into opaque and unregulated hedge funds.

Mortgage-backed securitisation vehicles are created when individual mortgages are sliced up and bundled together into packages that can be traded on – gambled on – by investors. The idea is that betting on the return of the bundled, securitised vehicle is supposedly less risky than betting on a single mortgage.

The main investment vehicles that held mortgage-backed securities in the 2000s were collateralised debt obligations (CDOs). CDOs were instruments that included slices of different bank loans, each with a different level of risk and a different interest rate. The rationale behind CDOs was that by pooling together risky loans with less risky assets, the overall risk profile would be lowered – the CDO would be able to gain a higher credit rating – and they would be more profitable for investors. But if one slice defaulted, it increased the risk of a default by the next slice in the bundle. The bad loans infected the rest of the sector until major investment banks could no longer put a price on certain securitisation vehicles.

The moment that marked the onset of the global financial crisis was not actually the collapse of Lehman Brothers in September 2008, but rather the moment in July 2007 when Bear Stearns found that it couldn’t put a value on a number of hedge funds that were contaminated with CDOs that included subprime mortgages in them. One of these hedge funds lost 90 per cent of its value overnight; another lost its entire value.

It is almost beyond comprehension that, just a decade on from the global financial crisis, mortgage-backed securities – and non-performing ones at that – are being posed by the Commission as a solution to a toxic debt crisis that is the legacy of the 2007-08 crisis, which these instruments literally caused.

Moving almost a trillion euros out of the regulated and relatively transparent banking sector into the opaque and almost totally unregulated shadow banking sector (by the existing ECB Guidance alone) is incredibly misguided and will pose massive new risks to financial stability in the EU and internationally. Expanding this process under the Directive for all future bad debt is incomphrehensible. How exactly does moving billions of euros of bad debt into the wild west of finance improve financial stability?

‘Buy when there’s blood in the streets’: enter the vultures

The Commission wants to move the toxic debt off the balance sheets of the EU’s banks so they appear healthy and well-functioning, and can compete internationally, particularly with US banks.

An 18th century banker is credited with coining the phrase that best defines the “contrarian” investor’s guide to make a killing in a financial crisis: “The time to buy is when there’s blood in the streets.” This principle underpins the strategy of the private equity funds referred to as vulture funds. You buy when the price is at rock-bottom and make a profit in the shortest possible time frame by any means necessary.

In the Ireland of today this means buying non-performing loans from banks at a fraction of their worth, and securing the underlying asset (usually people’s homes) as quickly as possible through making some sort of dodgy deal with the person who owes the debt, or simply throwing them out on the street.

The red-carpet treatment the Fine Gael-led government has provided to the vulture funds over the past five years – through open-door lobbying access, a virtually tax-free environment for most of the past five years, and consistent government opposition to attempts to rein them in through regulation – has made Dublin a favoured spot for US vulture funds to set up shop in.

Under the proposed EU Directive virtually all restrictions on “credit purchasers” (vulture funds) registered within the EU to operate across borders will be removed, and the fund will be bound only by the regulations of the EU member state in which it is registered. So the light-touch regulation of the Central Bank of Ireland may soon be the only line of defence against vulture funds preying on millions of indebted and impoverished borrowers across the EU.

Third-country credit purchasers – say a US vulture fund that has not set up a subsidiary in an EU member state at all – will simply have to designate a “credit servicer” (a debt collector) to enforce the credit agreement and not even bother with registering in the EU. Only the credit servicer and not the vulture fund itself will be regulated in any way under EU law.

This is precisely the political debate that has played out in the Irish state over the past three or four years. The owners of the credit agreement – the vulture funds – are the ones who make the key decisions regarding the distressed loan, including the setting of interest rates, whether to restructure a loan, and the enforcement of the loan. So it is crucial that the credit purchaser – and not only the credit servicer that acts as an intermediary – is authorised and regulated in the EU, and subject to supervision, investigation and sanctions by the national competent authorities in the member state in which it operates,.

Jettisoning the minor progress made in Ireland

In an Irish context, we have made only limited progress to date in terms of regulating vulture funds and protecting consumers and mortgage-holders. Yet even this modest progress made in the Dáil – usually in spite of Fine Gael opposition – will now be under threat by this EU Directive.

For years Irish campaigners for the rights of mortgage-holders have demanded that the vulture funds themselves, and not only the middlemen must be directly regulated by the Central Bank. Ireland’s Consumer Protection (Regulation of Credit Servicing Firms) Act 2018, which came into effect in January, is a positive step forward in that it allows the Central Bank for the first time to regulate, investigate and sanction the owners of the credit agreements and not just their designated debt collectors.

This modest but significant step forward in our framework for regulating vulture funds is now under threat by the EU Directive, as described above. The Irish government must defend our right to maintain this important piece of legislation in the European Council when negotiating this Directive, and all Irish MEPs in the European Parliament must also defend this position.

The second substantial potential piece of Irish legislation that must be defended from the EU is TD Pearse Doherty’s ‘no consent, no sale’ bill requiring banks to gain the written consent of their customers before selling their mortgage to a vulture fund; if this bill becomes law based on the will of our elected representatives in Dáil, it will be simply overruled by the EU through this Directive.

Campaigning for the Directive to be withdrawn

Leftists in the European Parliament have tabled amendments to the Parliament’s report on the Directive demanding the direct regulation of the vulture funds and not only their intermediaries; the need for banks to obtain the written consent of their customer before selling their loans on to a third party; a debt buy-back scheme for customers to have the right to purchase their own debt at the same reduced price that their bank would sell the loan to a vulture for; and for a range of additional consumer protection improvements to the Directive.

But these amendments are not enough. This Directive is a second bailout for the banks that gives free rein to the vultures and allows the banks to throw their customers under the bus. Minor improvements here and there won’t cut it. It needs to be scrapped in its entirety – and consumer rights groups, housing campaigners, human rights organisations and a range of political forces from across the EU will be organising a campaign in the coming weeks and months demanding this Directive be withdrawn .

Originally posted on Irish Broad Left

 

 

 

Sounding the alarm on the EU’s proposed Directive on non-performing loans

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Below is a letter to trade unions, farmers organisations, housing campaigners and others from Matt Carthy MEP raising alarm over the EU’s new proposed Directive on non-performing loans

10 January 2019

I am writing to inform you of a serious threat to the rights of borrowers and consumers arising from a proposed new EU Directive, which aims to develop a secondary market for non-performing loans. (Proposal for an EU Directive on credit servicers, credit purchasers and the recovery of collateral).

This proposed EU Directive is designed to promote the use of vulture funds and securitisation vehicles in order to move this bad debt off the banks’ balance sheets and into the opaque and unregulated shadow banking sector.

This proposal will also empower banks to seize their customers’ collateral through an out-of-court recovery mechanism, and will result in borrowers, including mortgage-holders, being pursued more aggressively by vulture funds and debt collectors.

1. Background

Non-performing loans (NPLs) are bank loans that are subject to late repayment or are unlikely to be repaid by the borrower. EU standards now generally require banks to classify loans as non-performing if they are more than 90 days in arrears. The ability of borrowers to pay back their loans deteriorated significantly during the financial crisis and the subsequent double-dip recession.

As a result, many banks saw a build-up of NPLs on their books, particularly in the countries worst affected by the crisis. While the average ratio of NPLs in the EU has decreased by more than one-third since 2014, the total volume of NPLs remains high, at around 900 billion euros.

Unfortunately the role of the EU institutions has been one of undermining the rights of homeowners and borrowers, to the benefit of the banks and vulture funds. Every attempt to regulate the debt vultures that we’ve seen in the Irish state in recent years – every draft piece of domestic legislation – has been referred to the European Central Bank for its ‘opinion’. The ECB’s opinion always seems to be that the banks should be allowed to get rid of their bad loans by any means necessary.

2. ECB Guidance to banks on NPLs (March 2017)

The ECB published its Guidance to banks on NPLs in March 2017, setting out the manner in which it expects banks to manage their NPLs. This Guidance is non-binding but subject to a comply-or-explain system in which supervised banks must explain deviations upon supervisory request, and in which non-compliance may trigger supervisory measures.

The Guidance only applies to the largest banks in the EU, which are supervised by the ECB’s Single Supervisory Mechanism. The Guidance states that each bank with elevated levels of NPLs is expected to develop portfolio-level reduction targets with a view to reducing the level of non-performing exposures on its balance sheet in a timely manner. The Addendum to the Guidance calls for these banks to enact a reduction plan if their level of NPLs passes a threshold of 5% of their overall balance sheet.

The ECB Guidance has been used by banks in the Irish state to prompt and justify their mass sell-offs of mortgages to vulture funds. However, the ECB has repeatedly stated that it “has not expressed a preference for certain NPL reduction tools over others”, and that the combination of tools or strategy reduction drivers for a given bank is the responsibility of, and chosen at the discretion of, its management.

3. Commission proposal on NPL package (March 2018)

In March 2018, the Commission made a specific legislative proposal based on four key aspects:

  • Provisioning by banks (banks putting aside their own capital to cover the loss of a bad loan);
  • Developing a secondary market for NPLs (promoting the sale of bad loans to vulture funds, and promoting securitisation);
  • Debt recovery (giving banks more power to enforce the collection of collateral through out-of-court recovery); and
  • Non-binding guidance for Member States on how to establish a national Asset Management Company (a bad bank, including possibly using public funds).

Unlike the ECB Guidelines, the Commission proposal applies only to future NPLs, not the existing stock. It is mandatory instead of non-binding and applies to all credit institutions, not only the biggest banks under ECB supervision.

The package consists of three different proposals from the Commission: a Regulation (on provisioning), a Directive (on developing the secondary market) and a non-legislative blueprint (on setting up national Asset Management Companies).

4. Analysis of the proposed package

On the proposed Regulation, I am generally in favour of the idea that banks should be required to put aside their own capital to cover the losses they incur when the loans on their balance sheets turn non- performing. This would incentivise banks to adopt more prudent lending standards. It would increase financial stability and lessen the likelihood of future public bailouts being necessary.

However, we cannot apply a one-size-fits-all reduction target that will incentivise banks to offload their loans onto the secondary market. My view is that banks should be required to keep their NPLs on their book and to work through them with their customers by writing down, restructuring or forgiving the debt, particularly in cases of residential loans.

i) Promoting securitisation

I am extremely concerned by the proposed Directive on credit purchasers, credit servicers and recovery of collateral. “Credit purchasers” refers to vulture funds and securitisation institutions, “credit servicers” means debt collection agencies, and the proposal for “debt recovery” is for accelerated out-of-court enforcement of loans secured by collateral (though consumer loans are excluded from this aspect of the proposal), meaning banks will be able to seize their customers’ property without going through the courts.

The Directive aims to promote the use of vulture funds and securitisation vehicles in order to move this bad debt off the banks’ balance sheets and into the opaque and unregulated shadow banking sector.

Moving hundreds of billions of euros of bad debt into the shadow banking sector through the securitisation of non-performing loans is incredibly misguided, and will cause major new risks to financial stability. Mortgage-backed securities in particular played the key role in the 2007-2008 crisis.

ii) Giving free rein to debt vultures

It seems to me that the Commission is trying to replicate the Irish model in reducing non-performing loans and impose this model across the EU. That’s why it is so important for Irish campaigners to highlight the massive problems that we have experienced – from the NAMA debacle to the mass sell- off of distressed loans to unregulated vulture funds. It is not a model to follow but a lesson in what to avoid.

The debt vultures will be encouraged to spread their wings and move from just operating in Ireland and Spain to operating across the EU, while securitisation will be promoted as a so-called solution to the non-performing loan problem.

A private equity fund will be able to register in one member state and get a “passport” to operate in any EU state, while only being bound by the regulations in place in the state where it is registered.

iii) A second bailout for the banks

This EU proposal is nothing less than a second bailout for the banks. The non-performing loan problem is a legacy of the 2008 financial crisis. This problem was not caused by ordinary people and they should not be forced to bear the brunt of resolving it.

The Commission says the new Directive is necessary in order to allow banks to lend to small businesses once again. But all of the evidence shows that the ongoing economic problems in the EU are not caused by a lack of lending, but a lack of demand in the economy. The only way to boost demand is to increase public investment and foster real wage growth.

The real goal of this proposal is not to ensure banks lend again but to ensure they return to making massive profits again.

iv) Directive will tie our hands on future regulation of vulture funds

Suggesting that the Irish model is a success story that should be replicated across the EU is bad news for borrowers in the rest of Europe.

But the worst part of this proposal is that it will put major restrictions on all future attempts to regulate vulture funds at the Irish level. Our hands will be tied behind our banks.

Say, for example, that public pressure forces the government to finally act to put in place measures to regulate the vultures in a meaningful way.

Unless these laws comply with the EU Directive – which, let’s not forget, is designed to promote the sale of debt to vulture funds – the legislation will be struck down because it will amount to an infringement of the “right of establishment” or “right to provide services” of these private equity funds.

5. Campaigning for the Directive to be withdrawn

I have been heavily involved in trying to shape this package of proposals in the European Parliament and will be very much focused on this in the coming months. The Commission has clearly not taken consumer protection issues or fundamental rights into consideration when conducting its impact assessment for this proposed Directive.

The Directive should be withdrawn, and I am investigating possibilities for legal action in this regard. The European Parliament must block this proposal from becoming law.

Sinn Fein will be organising an EU-wide campaign against this Directive in the coming months, together with other progressive forces and consumer protection organisations.

If the Directive is not withdrawn, we will attempt to insert the strongest possible protection of borrowers’ rights into this package, to ensure this proposal does not give free rein to vulture funds across the EU. Ensuring that strong protection for borrowers is included in this legislation is absolutely crucial.

Specific policy proposals we will campaign for if the Directive is not withdrawn include:

  • Banks must include a mandatory clause in their residential loan contracts that provide the customer with the option of denying the bank the ability to sell on their loan to a third party (no consent, no sale).
  • Banks must provide their customers with the option of purchasing their own debt at a reduced rate – rather than the bank selling this debt to a vulture fund at this same reduced rate.
  • Vulture funds and debt collectors operating in the EU cannot be given a “passport” to operate in one state but be bound only by the regulatory framework of the state in which they are registered.

I hope that all those campaigning here in Ireland for better protections for homeowners and farmers against evictions and the sale of their loans to vulture funds will also get involved in this campaign at the EU level. We need your voices to be heard by the European Parliament and Commission, and in particular, we need to force our own government to oppose this proposal at the Council level.

The Green Jersey: Is Ireland helping Apple pay less than 1% tax in the EU?

Below is an outline and summary of a new report I co-authored with Danish researcher Martin Brehm Christensen (University of Copenhagen), which examines Apple’s post 2014 Irish restructure, the effective tax rate it pays today as a result, and the role of the Irish government in facilitating industrial-scale tax avoidance by Apple and other multinationals.The report was commissioned by GUE/NGL and was launched on 21 June 2018 in the European Parliament in Brussels.

Apple’s Golden Delicious tax deals: Is Ireland helping Apple pay less than 1% tax?


Download the full report here: Apple tax structure and rate post-2014-3

This report was commissioned by GUE/NGL members of the European Parliament’s TAX3 special committee on tax evasion, tax avoidance and money laundering. It examines the corporate tax rate paid by Apple globally and in the European Union (EU) over the period 2015-2017, after it made significant changes to its corporate structure in 2015.

These changes were made in response to the United States (US) Senate Subcommittee on Investigations examination of Apple’s tax affairs in 2013, the European Commission’s 2014 investigation into state aid provided by Ireland to Apple, and the changes to Irish tax residence law ending the ability of companies to be “stateless” for tax purposes.

In addition to estimating the effective corporate tax rate Apple has paid from 2015-2017, this report also examines the nature of Apple’s 2015 corporate restructure, and the methods it uses to continue to avoid paying tax today. Lastly, it examines the features of Irish tax law and policy that facilitate Apple’s ongoing tax avoidance.

Tax rate in the European Union and globally 2015-2017

1) Apple may have paid as little as 0.7% tax in the European Union (EU) from 2015-2017.

2) Using data from Apple Inc’s 10-K filings to the US Securities and Exchange Commission, we estimate that as a result of the new Irish structure, and Apple’s broader global tax structure, Apple’s tax rate for the period 2015-2017 for its non-US earnings is between 3.7% and 6.2%.

3) Two alternative calculations of the average rate paid on non-US earnings reach similar results, of between 4.5% and 6.7%, and between 4.7% and 6.9%.

4) Using data from Apple Inc’s 10-K filings to the US Securities and Exchange Commission we estimate that Apple is paid corporate tax at a rate of between 1.7% and 8.8% in the European Union during the period 2015-2017. This estimate assumes that Apple’s provisions for foreign tax equals money actually transferred to foreign governments.

5) If we assume the highly likely scenario that Apple’s provisions for foreign tax is substantially smaller than the amount actually transferred to foreign governments, we estimate that Apple may have paid as little as 0.7% tax in the EU from 2015-2017.

6) Applying the range of estimated tax rates paid in the EU from 2015-2017, we estimate that Apple has avoided paying between €4 billion and €21 billion in tax to EU tax collection agencies from 2015-2017.

Apple’s Irish restructure in 2015

7) Apple’s new European tax structure remains shrouded in secrecy, partially due to a lack of financial transparency in Ireland and Jersey. Most of its financial information remains secret globally.

8) Apple continues to use Ireland as the centrepiece of its tax avoidance strategy. Following the US Senate inquiry (2012-2013) and the initiation of the European Commission’s state aid investigation into Ireland (2014), Apple organised a new structure in 2015 that included:

  • The relocation of its non-US sales from ‘nowhere’ to Ireland;
  • The relocation of much of its intellectual property from ‘nowhere’ to Ireland;
  • The relocation of its overseas cash to Jersey.

9) As well as relying on the information revealed in the Paradise Papers and Apple’s statement responding to these revelations, this restructure can be observed in the macro-economic data of Ireland from 2014-2018, particularly in the first quarter of 2015. Major changes occurred in  Ireland’s GNP, GDP, exports, imports, investment, external debt and more. Despite the relocation of sales income and intellectual property to Ireland, there was no observable corresponding increase in corporation tax received from Apple by Irish Revenue.

10) With the assistance of the Irish government, Apple has successfully created a structure that has allowed it to gain a tax write-off against almost all of its non-US sales profits.

Apple is achieving this by:

  • Using a capital allowance for depreciation of intangible assets at a rate of 100% (this rate will be capped at 80% from 2017, but the cap will not apply to the intangible assets brought onshore from 2015-2016, which can still benefit from the 100% rate);
  • A massive outflow of capital from its Ireland-based subsidiaries to its Jersey-based subsidiaries  in the form of expenditure on IP and debt;
  • Using interest deductions of 100% on this intra-group debt;

11) The Irish government introduced the 100% rate on capital allowances for intellectual property (IP) following a recommendation made by the American Chamber of Commerce in Ireland in 2014.

12) The law governing the use of capital allowances for IP is not subject to Ireland’s transfer pricing legislation, but it includes a prohibition from being used for tax avoidance purposes. Apple is potentially breaking Irish law by its restructure and it exploitation of the capital allowance regime for tax purposes. If the same legal reasoning used in the European Commission’s state aid ruling on Apple and Ireland is applied, Apple is in breach of Irish tax law, and owes Irish Revenue at least 2.5 billion additional euros in unpaid tax annually from the period 2015-2017.

13) The use of this structure has contributed to a significant increase in the amount of cash Apple is sitting on in offshore tax havens.

Features of Irish tax law that enable Apple’s tax avoidance

14) Apple is unlikely to be the only multinational corporation using this structure, which is advertised as a typical structure used by large corporations involved in trading in intellectual property by corporate law firms. We have called it the “Green Jersey” in reference to the use of the Jersey-based subsidiary by Apple, though it is not strictly necessary to use an offshore tax haven as Apple has.

15) The essential features of the Green Jersey scheme are:

  • It can be used by large multinational corporations engaged in trading IP;
  • It has specifically been designed by the Irish government to facilitate near-total tax avoidance by the same companies who were using the Double Irish tax avoidance scheme;
  • While the Double Irish was characterised by the flow of outbound royalty payments from Ireland to Irish-registered but offshore tax-resident subsidiaries, this scheme is characterised by the onshoring of IP and sales profits to Ireland;
  • Sales profits are booked in Ireland, but the expenditure the company incurs in the once-off purchase of the IP license(s) can be written off against the sales profits for years by using the capital allowance programme for intangible assets;
  • It is beneficial for the company to complement the tax write-off by continuing to use an offshore subsidiary, but not for outbound royalty payments to flow to. The role of the offshore subsidiary is to store cash and provide loans to the Irish subsidiary to fund the purchase of the IP. The expenditure on the IP is written off, but so too are the associated interest payments made to the offshore subsidiary, which thus accumulates more cash that goes untaxed.

16) Many of the features of Irish tax law that were identified as factors facilitating tax avoidance in the Commission’s state aid ruling remain partially or fully in place in Ireland. Despite the announced phase-out of the Double Irish scheme, we have found that the “management and control” provision allowing the creation of Double Irish structures remains in place through several of Ireland’s tax treaties, including treaties with states considered to be tax havens.

17) Several other key features of Ireland’s tax regime that were criticised in the context of the Apple state aid ruling, and which remain fully or partially in place, include:

  • Ireland’s intellectual property tax regime including R&D credits that are open to abuse, and the lack of withholding taxes on outbound patent royalty payments;
  • The use of private “unlimited liability company” (ULC) status, which exempts companies from filing financial reports publicly. The fact that Apple, Google and many others continue to keep their Irish financial information secret is due to a failure by the Irish government to implement the 2013 EU Accounting Directive, which would require full public financial statements, until 2017, and even then retaining an exemption from financial reporting for certain holding companies until 2022;
  • Ireland’s one-way transfer pricing laws that examine only the Irish-resident party involved in a transaction;
  • Continued use of Advanced Pricing Agreements and Revenue “opinions”, which may not be subject to the same requirements on mandatory automatic exchange of information between EU member states under the third EU Directive on Administrative Cooperation.

Download the full report here: Apple tax structure and rate post-2014-3

The monetary policies of the ECB – Europe’s unelected government

MONETARY POLICY is a key tool for governments to use to benefit citizens, societies and economies. Central banks are empowered to determine interest rates, and to influence the exchange rate of their currency (and others’) by buying and selling reserves of foreign currencies. If a central bank sets a higher interest rate, this makes the return on this currency higher, leading to a higher demand for the currency and a resulting higher exchange rate. By lowering interest rates central banks can stimulate growth by expanding credit. With the creation of the ECB in 1998, members of the common currency transferred their power to set interest rates and other monetary policy powers to the ECB, which would set a centralised monetary policy across the Eurozone. The ECB and national central banks form the European System of Central Banks (ESCB), and the ECB can “exceptionally” provide emergency liquidity assistance (ELA) as a last resort for struggling Eurozone banks. The ECB differs from most of the other major central banks around the world in that it has a more limited mandate, and in its governance structure.

A narrow mandate

The neoliberal ideas, and the German economic ideology of ‘Ordoliberalismus’, that shaped the construction of the Eurozone can also be seen starkly in the nature of the ECB. This ideology has been dominant in Germany since the Second World War and combines a belief in a welfare safety net with the view that one of the government’s key roles is to promote market competition, stressing the importance of constitutional rules, as opposed to the use of discretionary policy. This ideology shaped the nature of the Bundesbank, which was dedicated to tightly controlling the money supply to maintain price stability. The ECB was constructed on this model, with a mandate to focus on price stability – controlling inflation. Despite the total discrediting of this ideology in the wake of the financial crisis, Berlin’s belief that if the government ensures inflation is kept low and stable, then markets will ensure growth and employment of their own accord, persists.

The ECB’s mandate is in contrast to many other major central banks, like the Federal Reserve in the US, which are tasked with the broader role of maintaining full employment and promoting growth, in addition to maintaining price stability. As a result of its narrow mandate the ECB only focuses on controlling inflation, regardless of how high the unemployment rate is. If there is low and stable inflation in the Eurozone as a whole – and in Germany in particular – then the ECB will ignore the growth needs of states experiencing high employment. In the midst of the recession and the sovereign debt crisis in 2011, the ECB actually raised interest rates twice, in April and July, contributing to the cause of the Eurozone’s double-dip recession. This caused major hardship in the crisis countries, particularly for mortgage-holders who were pushed further into arrears.

The other key difference between the ECB and other major central banks is its level of democratic accountability: for example, while the Fed is often described as “independent”, it is ultimately accountable to Congress. The ECB is unaccountable to any elected government or parliament. This feature reflects the drive by elites to “depoliticise” economic policy by outsourcing it to supposedly independent technocrats in order to weaken resistance to highly political decisions that have profound redistributive consequences for society. Bill Mitchell and Thomas Fazi write: “[T]he creation of self-imposed ‘external constraints’ allowed national politicians to reduce the political costs of the neoliberal transition – which clearly involved unpopular policies – by ‘scapegoating’ institutionalised rules and ‘independent’ or international institutions, which in turn were presented as an inevitable outcome of the new, harsh realities of globalisation, thus insulating macroeconomic policies from popular contestation”.

The decisions that the ECB has taken in response to the crisis have been extremely political, such as its decision to raise interest rates in 2008 and 2011, when the real danger to the majority of Eurozone members was deflation. The two most strikingly political acts during the crisis were the ECB’s threat to cut off emergency liquidity assistance to the Irish state unless it agreed to request a bailout, and its decision to cut off emergency liquidity to Greek banks in the middle of 2015 in a threat to Syriza that Greece would be forced out of the Eurozone if it did not submit to the conditions of the Troika that were resoundingly rejected by Greek voters in a referendum. The ability to withhold credit to elected governments gives the unaccountable ECB an enormous degree of power to impose its own policy on countries in need of assistance.

The ECB’s financing operations

In 2011 the ECB began the first of several financing operations in order to assist the economic recovery in the Eurozone. In December 2011 it announced its long-term refinancing operation (LTRO), which provided one trillion euro in credit in secured funding to troubled banks at a rate of one per cent interest. The banks often invested it into government bonds at higher rates, which helped the banks’ balance sheets but cost government budgets in debt servicing payments, and tied the banks and sovereigns even closer together.

As the Eurozone teetered on the brink of fragmenting in July 2012, ECB President Mario Draghi made his famed speech that is widely believed to have “saved” the common currency, which included the statement that, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. The speech preceded a new financing operation called Outright Monetary Transactions (OMT) in which the ECB offered to purchase sovereign bonds of the most indebted states. In 2014 Paul Krugman described the OMT programme as a “bluff” because “nobody knows what would happen if OMT were actually required”. The OMT programme has not in fact ever been used, because no member state has met all of the requirements needed to activate it. Martin Wolf and others have observed that the bluff was so successful not only due to its announcement, but also due to the tacit acceptance of the announcement by all member states including Germany, as this was perceived by markets as a signal that the risk of the Eurozone disintegrating was eliminated. But he adds that while the spreads between government bonds in crisis and core countries fell sharply in response to the OMT announcement, they remain significant. “For countries caught in a deflationary trap, these spreads might yet prove unmanageable.”

In a telling side note, it was revealed in October 2017 that the Eurosystem had made super-profits of €6.2 billion between 2012 and 2016 from Greek bonds the ECB had purchased at knock-down prices in 2012. While the Greek government and its creditors in 2012 had agreed to “haircut” Greek bonds, those purchased by the Eurosystem were conveniently excluded.

Neither the LTRO nor the OMT programmes did much to actually improve the supply of credit to the productive economy. The next financing operation was announced in 2014 – targeted longer-term refinancing operations (TLTRO) – and it was aimed at providing banks with funds on the condition that they would be used to supply credit to small and medium enterprises as opposed to being directed towards speculation. But the lack of demand in the economy has meant that the TLTRO offer was not widely taken up by firms. Despite the ultra-low and at times negative interest rates, and the billions of euros handed over to banks through its financing operations, the ECB was not able to generate recovery in the real economy and restore growth, and it has persistently missed its target of 2 per cent inflation.

In March 2015, the ECB announced a quantitative easing (QE) programme in which it would create €60 billion each month and use it to purchase corporate sector assets and government bonds. It was originally intended to last for one year but has been extended and remains in place, though economists expect the announcement of “tapering” in the near future, the phased winding-down of the programme. The Corporate Securities Purchasing Programme (CSPP), introduced in March 2016 and now valued at around €125 billion, has been widely criticised by NGOs and MEPs for the lack of transparency on how the bonds are selected, and the fact that the funds are being directed towards multinational corporations and the fossil fuel industry. Corporate Europe Observatory has examined the limited publicly available data on the bonds favoured by the CSPP and found a marked preference for climate-damaging corporations. Another report by Corporate Europe Observatory published in October 2017 found that 98 per cent of all advisors in the ECB’s advisory groups have been assigned to representatives of the finance industry. Just three financial institutions, Deutsche Bank, BNP Paribas and Citigroup, occupied 208 out of 517 total advisory seats.

The QE for People and Positive Money campaigns have developed a detailed critique of the limited impact on real economic recovery of the ECB’s “trickle-down” QE programme and have developed excellent policy alternatives. This campaign is supported by dozens of leading economists. Two examples of alternative monetary policies they propose are for the ECB to transfer newly created money to Eurozone governments directly, who can use it to increase public spending on green infrastructure and services; or for the ECB to create money that can be directly distributed to citizens of the Eurozone, which would increase their purchasing power and directly enter the real economy. The current QE programme is not only unfair and ineffective – it is also increasing financial volatility and encouraging the inflation of new speculative bubbles.

A new banking crisis?

Despite the fact that the European banking sector has received more than €1.6 trillion through taxpayer-funded bailouts since 2008 – and despite the fact that the ECB has pumped in €60-€80 billion each month through its financing operations since March 2015 amounting to an additional €2 trillion in support – another crisis is unfolding in the European banking sector.

Banks in the EU, and particularly in the Eurozone, have been experiencing a chronically low level of profitability since the global financial crisis. While profitability of US and British banks has improved somewhat post-crisis, many Eurozone banks are struggling to keep their heads above water.

ECB Vice President Vítor Constâncio noted in a speech in Brussels in February that the key measure of profitability – return on equity – for euro-area banks “has hovered at around 5 per cent”, a rate which, he pointed out, “does not cover the estimated cost of equity”. By contrast, the return on equity in the US has recovered to above 9 per cent (around the current cost of equity in the euro area banks), and the industry generally considers 10 per cent to be a good rate of return. European banks’ income from interest, which was on average 19 per cent of their equity in June 2016, is less than their operating expenses of 20.9 per cent, according to the European Banking Authority (EBA).

The crisis has been demonstrated in the failure (or near-failure) of several banks across the Eurozone this year – including Italy’s Monte dei Paschi di Siena (MPS), Veneto Banca and Banca Popolare di Vicenza, and Spain’s Banco Popular – as well as the serious ill-health of German giant Deutsche Bank. Other banks that have caused concern, largely due to the results of the 2016 banking stress tests carried out on 51 major EU banks under the authority of the EBA, include RBS, which was bailed out by the British government in 2008 in the world’s largest ever bailout, and has since posted nine straight years of losses. Irish banks Allied Irish Bank and Bank of Ireland, British bank Barclays, Switzerland’s Credit Suisse and Austrian bank Raiffeisen are all also subject to concerns about their health and viability.

In an illustration of the seriousness of the systemic risk posed by the profitability crisis, EBA chairperson Andrea Enria said last October: “The problem is European in scale: we have more than €1 trillion of gross non-performing loans in the system; even considering provisions [money set aside to cover losses], the stock of uncovered non-performing loans is at almost €600 billion — more than all the capital banks raised since 2011, more than six times the annual profits of the EU banking sector, more than twice the flow of new loans.

“For supervisors, this casts serious doubts on the long term viability of significant segments of the banking system [my emphasis]. The same concern is shared by investors and is reflected in the low valuations registered in stock markets.”

Most experts and financial commentators point to four key contributing factors to this lack of profitability – the high volume of non-performing loans on the banks’ books (loans that are in default after 90 days of non-repayment); the very low interest rate environment arising from the ECB’s recent monetary policy; the fines for misconduct banks have been required to pay since the crisis; and over-capacity in the sector, including increasing competition from FinTech.

Between 2010 and 2014, EU banks paid out around €50 billion in settlements and fines imposed by regulators for misconduct, largely due to mis-selling the risky financial products that contributed to the global crash. The EU’s largest banks, those classified as global systemically important banks (G-SIBs), were the worst culprits and paid the vast majority of the €50 billion figure. A report by the European Systemic Risk Board in 2015 found that past and looming fines would wipe out erase basically all of the new capital that had been raised by European G-SIBs over the past five years.

While misconduct fines and over-capacity dampen profits, the two most important of the four factors listed above are the NPL problem and the interest rate environment. But a key pressure on profitability that the ECB, EBA and the other EU institutions routinely fail to acknowledge is on the demand side – ie, the general economic stagnation in the Eurozone that has caused the demand for credit to fall and remain low. This stagnation has also contributed to and worsened the NPL problem. Euro-area banks held just over €1 trillion in NPLs last year, the equivalent of around 9 per cent of the Eurozone’s GDP, and amounting to around 6.4 per cent of total loans in the Eurozone. The level of NPLs differs dramatically across the euro area, with almost half bank loans in Greece and Cyprus now classified as NPLs, and Italy, Ireland, Portugal and Slovenia all holding NPLs at rates of 10-20 per cent.

There is a clear overlap between the high level of NPLs and the impact of the financial crisis on the so-called peripheral economies in the Eurozone, and a clear interaction between the austerity measures prescribed for these economies by the Troika and their inability to significantly reduce their NPL ratios. The collapse of the industrial sector in Greece and Italy in particular has been a major contributing factor to the rise of distressed loans as businesses of all sizes failed and their owners were unable to repay loans. The austerity policies enforced by the Troika in the crisis countries in return for bailout funds inevitably exacerbated the NPL problem.

Publicly funded bank bailouts are back with a vengeance

“EU forges bank bailout deal to protect taxpayers” – that was the Associated Press headline in June 2013, describing the agreement reached in Brussels on the EU Banking Union. The Banking Union is an initiative to further integrate the banking and financial sectors in the Eurozone countries, which was promoted as a response to the global financial crisis and subsequent sovereign debt crisis. It is envisioned as having three pillars based on a “single rulebook” – a system of harmonised supervision under the Single Supervisory Mechanism; a single resolution mechanism and associated fund implemented by the Bank Recovery and Resolution Directive (BRRD) at the beginning of 2016; and an as-yet to be developed third pillar of a European Deposit Insurance Scheme.

The Banking Union, European lawmakers assured the public, would call time on the “too-big-to-fail” problem and ensure taxpayer-funded bailouts – which had cost EU governments more than €1.5 trillion since 2008, including €64 billion in the Irish state – were a thing of the past. The BRRD was supposed to make sure that in case of a bank failure, the institution would be wound down in an orderly way by an early intervention by regulators, and that senior bondholders and depositors with more than €100,000 in the bank would be “bailed in”. Creditors would have to incur losses of at least 8 per cent of their liabilities before a bank would be able to receive government aid. Speaking to reporters at the summit where the deal was reached between EU Finance Ministers that day in 2013, then-Irish Finance Minister Michael Noonan said: “Bail-in is now the rule… This is a revolutionary change in the way banks are treated.” But there was an exception clause, as there usually is in EU legislation, and its name was “precautionary recapitalisation”.

Resolution Directive fails miserably in its first test

The Italian banking crisis that deepened throughout 2016 culminated in the December announcement by the Italian government of a €20 billion taxpayer-funded rescue package for the ailing MPS and other Italian banks, indicating its intention to activate the precautionary recapitalisation clause of the BRRD. The clause allows for the bail-in of creditors to be sidestepped if certain conditions are met – namely that the bank is still solvent, and its resolution would threaten financial stability. This exceptional clause is complemented by a similar “safeguard” clause in the EU’s state aid legislation on burden-sharing.

After months of negotiations between the European Central Bank (ECB) and the Commission, about both the extent of the capital shortfall and the terms of the deal, Competition Commissioner Margrethe Vestager reached an agreement in principle with the Italian Finance Minister on June 1, 2017. The Commission, and the ECB in its supervisory role, gave the green light to the precautionary recapitalisation. “State aid in this context can only be granted as a precaution (to prepare for possible capital needs of a bank that would materialise if economic conditions were to worsen) and does not trigger resolution of the bank,” Vestager said in a statement.

Conditions of a precautionary recapitalisation include that broader financial stability must be threatened by the bank’s failure; the state support cannot be used to cover previous or near-term expected losses; and the need for state support must be only temporary. But MPS already received two state-funded bailouts in 2009 and 2012, casting significant doubt on whether it meets these two latter criteria.

Back in December when the Italian government made its rescue package announcement, the ECB suddenly began to say that MPS’s capital shortfall was not €5 billion as previously estimated but actually €8.8 billion. The ECB didn’t bother to explain publicly how it arrived at this figure, but its retroactive and opaque revision of the figures raised serious concerns and questions about the health of MPS. Was the bank actually solvent when it applied for a precautionary recapitalisation? If not, it would not qualify for public assistance. The details of the Commission’s agreement in principle have not yet been made public.

There are many criticisms that can be made of the resolution aspects of the Banking Union legislation. The bail-in of creditors of only 8 per cent is, in many cases, going to raise a totally insufficient proportion of the costs of a resolution. In ordinary insolvency procedures investors would usually lose far more than 8 per cent. Bail-in also poses additional risks to ordinary taxpayers in a number of ways including through increased premiums in pensions and health insurance, and through the mis-selling of risky and inappropriate financial products that are eligible for bail-in to small retail investors.

The precautionary recapitalisation clause, however, is the glaring loophole that makes a joke out of the Banking Union’s promise to end taxpayer-funded bailouts of banks and to resolve the ‘too-big-to-fail’ problem. Under the Bank Recovery and Resolution Directive, a review of the precautionary recapitalisation clause was supposed to have taken place by now. The Commission was required to review whether “there is a continuing need for allowing the support measures” in the clause by December 2015 and report on this to the European Parliament and Council, which it has failed to do.

Now, the European Banking Authority (EBA), supported by many within the European Central Bank (ECB), is making a concerted push for the precautionary recapitalisation loophole to be invoked in order to use public funds to bail out the big bank across the EU more generally, by calling for state funds to be used to reduce the high level of non-performing loans in European banks and to restore them to profitability.

A crisis of abundance

Writing in response to the Great Depression, Keynes said, “This is not a crisis of poverty, but a crisis of abundance,” a description that is perfectly fitting for the current economic crisis. The ongoing tendency towards stagnation in the Eurozone and in the broader economy is not primarily the result of trade imbalances, which in any case, have been reduced as a result of the fall in aggregate demand. There is an unprecedented mass of money not being used in the economy, which has built up over decades of a declining labour share of income and record-high corporate profits. There is at least US$5 trillion in “idle money”, much of it resting in tax havens. Varoufakis writes: “Try to imagine the mountain of cash on which corporations in the United States and Europe are sitting, too terrorized by the prospect of insufficient consumer demand to invest in the production of things that society needs.” He notes that every crisis generates two mountains: “one of debts and losses, another of idle, fearful savings” – the only difference being the scale of this crisis.

Investment continues to stall across the Eurozone, and the Juncker Investment Plan, and its key instrument, the European Fund for Strategic Investment (EFSI), has been a dismal failure. It was announced in late 2014 as an initiative from the Commission in partnership with the European Investment Bank (EIB) in order to address the ‘investment gap’ that the Commission estimates to be 200-300 billion euros per year in the EU. The stated goal of the Juncker Plan was to “mobilise” more than €300 billion in private capital investments – by creating an initial fund of just €21 billion to secure loans for infrastructure projects. The European Trade Union Confederation immediately responded to the Juncker Plan by saying the Commission was “relying on a financial miracle like the loaves and fishes”.

There was no new money forming the EFSI – the seed capital was cut from other existing EU budgetary programmes, including the research plan Horizon 2020 and the Connecting Europe transport infrastructure programme. This €21 billion in initial capital was to be used to guarantee €60 billion of EIB borrowing to fund riskier projects than the EIB usually funds. The entire rationale of the Juncker Plan was to ensure that private investment that would otherwise not have happened took place. The investment plan stipulates that the funds must be disbursed across all EU economies according to the size of their GDP levels, meaning most of the projects that have been approved have benefited Germany and Britain instead of the smaller peripheral economies who are in greater need due to the fact that investment has largely ground to a halt. It has largely focused on public-private partnerships, which are being used across the EU to promote privatisation of public goods and services.

The Bruegel think-tank undertook a study of the first 55 EFSI-funded projects that were approved in the first year, and found that 42 would in all likelihood have proceeded anyway in the absence of the Juncker Plan. The only difference is that public money is now being used as a guarantee for private ventures.

The European Parliament admits the results of the Juncker Plan have been disappointing and that it has failed to unleash any discernible surge in investment. The most critical group, the European United Left (GUE/NGL) points out that most of the investments made under the plan would have proceeded regardless, without the EU guarantee, but now private investors can shift the risk of their investments to taxpayers. The group argues, “The EFSI induces rent seeking and asset stripping by private investors at the expense of the Union budget, via public private partnerships, the privatization of profits and the socialization of losses, while only sparely contributing to additional investment”.

This is an excerpt from the economic discussion document launched by MEP Matt Carthy on October 27, entitled The Future of the Eurozone. Download the full document for a referenced version of Chapter Six, above.

 

Trade unionists rally against French President Emmanuel Macron's attacks on labour rights with a banner saying "Macron, puppet of the employers" (AFP)

Eurozone’s architects opt for ‘internal devaluation’

What conditions are required for a monetary union to work?

WHAT are the necessary requirements for a common currency to actually work effectively to the benefit of all its members? Why do the dollar-zones in the US, Canada and Australia not experience the same level of crisis, divergence and stagnation as the Eurozone has been plagued with? Simply put, the institutions in place in federal states such as these allow for the smooth, timely and effective recycling of excess profits from surplus states to those experiencing deficits. They also have central banks that have a mandate to ensure full employment, as well as price stability. In comparison, following the Bundesbank model, the ECB’s mandate is solely to maintain price stability and it is not to concern itself with employment.

When a downturn or crisis hits a common currency area, it will cause an asymmetric shock unless there has been sufficient convergence in the economies of the union. Divergent economies would be affected differently by different external and internal developments. This danger was understood by the architects of the euro, but for ideological reasons they focused only on attempting to achieve convergence in government debt and deficit levels at Maastricht and ever since, instead of looking at the more important role of divergence in balance of payments between members.

In 1961, economist Robert Mundell articulated his ‘optimum currency area’ theory on how currency unions could work to overcome asymmetrical shocks. The adjustment mechanisms identified through this theory include price and wage flexibility; mobility of labour and other factors of production; financial market integration; a high degree of economic openness; the diversification of production and consumption; similar inflation rates; fiscal integration; and finally, political integration. Some of these mechanisms can be seen to work effectively in the US. The three most important factors in place in the US economy identified by Stiglitz and others are: (1) the ease of migration across states, (2) federal spending on national programmes, and (3) the fact that the US banking system is a federal and not state-based system.

If one state in the US experiences a shock, workers can easily migrate to another state in a better economic condition in order to look for work. Technically there is freedom of movement of labour in the EU, but in practice migration within the US is far easier due to the fact states share a common language, a common culture and national identity, and the same access to federal welfare programmes. National government programmes such as social security and Medicare are available across all states, which means that if one state is experiencing a downturn, the federal government will automatically recycle surpluses towards the state in trouble in the form of, for example, increased unemployment benefits. Around one-fifth of GDP is spent at the federal level in the US. The federal government can also choose to boost investment or spending in certain federal projects at the state level in order to aid economic recovery. By comparison, in the Eurozone there is very little fiscal capacity to redirect funds towards depressed states because the European budget is around one per cent of member states’ GDP. Almost all spending occurs at the member state level. US banks are also guaranteed at the federal level by the Federal Deposit Insurance Corporation, preventing capital flight from one state to another in times of crisis.

Clearly the EU lacks similar institutions. But with the exception of a common deposit insurance scheme, the creation of such adjustment mechanisms in the Eurozone is either impossible in the short-to-medium term, or completely undesirable from a left standpoint by virtue of the fact that increased economic, fiscal and political integration require unacceptable trade-offs in the ability of people to participate in the decision-making process democratically at the local and national level.

Eurozone’s architects opt for internal devaluation

Of the various adjustment mechanisms identified by optimum currency area theorists, the Eurozone’s founders have clearly focused single-mindedly on attempting to achieve ‘flexibility’ of wages. Countries inside a common currency area cannot engage in competitive devaluations by devaluing their currency to make their exports more competitive. But they can implement policies domestically to bring about an ‘internal devaluation’ – lowering their real exchange rate vis-à-vis their neighbours. The main way this takes place is by compressing or reducing wages, which causes prices to fall. Germany has consciously implemented this policy for several decades, at the expense of German workers, millions of whom are working but living in poverty. This long-term strategy was intensified in 2003 under the then social-democrat/Green coalition government, which carried out a radical and vicious reform of the labour and welfare systems entitled Agenda 2010.

The competitiveness of prices largely determines the performance of a country’s exports, and the key factor determining prices is the nominal unit labour cost (the nominal unit labour cost is the ratio of labour cost per employee to productivity – the value added per worker). Unit labour costs in Germany stopped growing in the mid-1990s. Between 1998 and 2007, the rise in unit labour costs in Germany was zero. But in the rest of the Eurozone over the same period, average wage costs mainly increased with inflation, of around 2 per cent per year. This difference greatly increased the competitiveness of German exports and reduced it for the exports of other Eurozone members. So the success of Germany’s economic model is at the expense of the rights and living standards of its workers. The Agenda 2010 strategy has been deepened under successive governments and by 2015, more than 12.5 million Germans, out of a population of 80 million, were living in poverty in Europe’s “economic powerhouse”.

The EU’s focus on structural reform, particularly labour market reform, with a view to achieving increased “flexibility” has been a constant feature of its agenda since Maastricht. This was a major element of the Jobs Strategy of 1994, and the Lisbon 2010 Agenda adopted in 2000. The Lisbon Agenda originally set out to make the EU “the most competitive and dynamic knowledge-based economy in the world” by 2010. It included an economic pillar, a social pillar and an environmental pillar. In 2005, the Lisbon Agenda was revised by the European Council and Commission. Their verdict was that the agenda was failing to achieve its goal, and so they decided to drop the social and environmental pillars and focus on the economic pillar. In 2010 the Lisbon Agenda was relaunched as a new 10-year plan, the Europe 2020 strategy – “an agenda for new skills and jobs: to modernise labour markets by facilitating labour mobility and the development of skills throughout the lifecycle with a view to increasing labour participation and better matching labour supply and demand”.

The “progress” of member states in implementing structural reforms that will facilitate downward movement on wages is monitored through the European Semester process, a yearly cycle of policy “coordination” between member states and the Commission. In spring each year, Member States submit their plans for managing public finances – including keeping debt and deficits within the Stability and Growth Pact limits – and their National Reform Programmes to achieve “smart, sustainable and inclusive growth”. These plans are then assessed by the Commission, which proposes country-specific recommendations to member states, which are discussed and adopted by the Council. Then each autumn member state governments are graciously permitted to present their draft national budgets to their respective parliaments. The Five Presidents’ Report of EU leaders of 2015 proposed the creation of National Competitiveness Authorities to advance this agenda further.

The Eurozone elites believe (or claim to believe) that if only “wage rigidities” in the member states were overcome, both unemployment and trade imbalances would disappear. If only a country’s population could be forced to work for poverty wages, there would be a job for everyone; and the resulting stagnation in domestic demand would mean prices would fall and this country’s real exchange rate, which had become misaligned and risen too high, could regain its balance. This view underpins the repeated attacks on the rights and wages of French workers, set to intensify fiercely under President Macron, as well as underpinning the EU’s overall agenda and forcing structural reforms in the member states in order to increase productivity and competitiveness – and profit, of course. The austerity imposed by the Troika was not only designed to regain market “confidence” in peripheral governments, but also to facilitate internal devaluations in member states by a form of shock therapy. Of course, this adjustment facilitates not only the reduction of trade imbalances but also a sharp increase in the amount of wealth transferred from labour to capital.

There has certainly been an internal devaluation process in the Eurozone countries, affecting primarily the peripheral economies. But as Stiglitz points out, “this has not worked – or at least not fast enough to restore the economies to full employment. In some countries such as Finland, low inflation not been enough to even restore exports of goods and services to the levels before the crisis”. An increase in exports in these countries should have boosted growth and employment. But with the exception of the hugely distorted “globalised” data from the Irish economy, this has not been the case. The restoration of trade balance that the Eurozone has experienced since the crisis has largely been due to the fact that imports fall when demand stagnates – “one can achieve a current account balance by strangulating the economy”. For the crisis countries, the reduction in their trade deficits post-crisis largely resulted from a reduction in imports and not an increase in exports.

Crucially, internal devaluations also increase the level of debt of households, firms and governments who have borrowed in euros – as the value of their income is depressed, they owe a higher proportion of their income. High levels of debt were a major factor in causing the recession, because those in debt cut back on spending on both imports and domestic goods, causing a decline in GDP. It has also contributed greatly to the lingering problem of non-performing loans burdening Eurozone banks, particularly in the crisis countries.

This is an excerpt from the economic discussion document launched by MEP Matt Carthy on October 27, entitled The Future of the Eurozone. Download the full document for a referenced version of Chapter Five, above.

 

A protester waves the tricolour at a protest against the Troika bailout of Ireland in 2010

Some euros are more equal than others: trade imbalances and debt crises

WHY WERE leaders of European Union countries so determined to establish a monetary union among member states despite the setbacks and shocks experienced in the first decades of such an attempt at creating a common currency? In part it was a response to the collapse of Bretton Woods, and in part it was viewed by committed European federalists as a way to push the pace of political integration. There was a widespread belief stretching back to the Gold Exchange Standard that a common currency would ensure price stability and predictability, eliminate the risk of changes in exchange rates and therefore boost trade. For the European deficit states, the susceptibility of their currencies to repeated devaluations against the Deutschmark was viewed as an economic and political vulnerability, which caused inflation that reduced the purchasing power of both rich and poor. Meanwhile, from the mid-1980s the expanding US deficit had allowed both Germany and the EEC as a whole to generate a trade surplus. For the technocrats that had already set up shop in the limited European community administrative bodies, the creation of the euro would speed up the process of political integration and movement towards a European federation.

A shared currency with different motivations

Successive French governments had repeated the call for a European monetary union since Giscard d’Estaing first proposed it in 1964, with a view to reining in German power – and to make it easier to impose wage restraint on French workers, by comparing their wages with those of German workers. French national expertise in constructing political institutions would also be able to shine in a European administration. Germany had dragged its heels on such a union for decades, largely because of a fear that a fixed exchange rate between the franc and the Deutschmark would require the Bundesbank to print more money to prop up the franc, causing inflation that had been regarded with profound dread by Germans since their experience of the hyper-inflation of the 1920s, a dread that continues to define German monetary policy today.

The typical explanation regarding the creation of the Economic and Monetary Union (EMU) found in history books is that Germany finally agreed to the long-standing French call for a monetary union after the fall of the Berlin Wall in exchange for French acceptance of Germany’s reunification. But it was also created to accommodate Germany’s export-led economic strategy. The Deutschmark’s sky-high value in the wake of the collapse of Bretton Woods was a reminder to Germany that if the Deutschmark’s exchange rate was to float freely its value could rise indefinitely, making its exports too expensive and destroying its trade surplus strategy. Competitive currency devaluations were successfully reducing Germany’s trade surpluses with the countries that used them during the 1980s. Germany needed some way of locking its exchange rate to other currencies after the demise of the dollar zone. The ERM was viewed as a partial solution to these problems by German political leaders and the Bundesbank. But the speculative attacks on the currency fluctuations possible within the ERM that caused its collapse in 1992 led Germany to finally accept the creation of a common currency – on the condition that the deflationary debt and deficit rules of the Maastricht convergence criteria were accepted by its neighbours, of course.

Germany’s biggest export – stagnation

The question of how to deal with chronic, persistent trade imbalances within a common currency area was resolved to a large degree under the Bretton Woods system by the American commitment to spend its surplus internationally – its direct injection of capital into the economies of its capitalist allies during the duration of the system through aid and then investment. In this way, the US exported its goods but it also exported demand. The German model, on the contrary, aims to export its goods and import demand from other countries. In this way, the biggest German export can said to be stagnation. Instead of playing a role of recycling surplus profits, generating growth and stabilising the international economic system, the persistent German surplus plays a destabilising and deflationary role in the monetary union.

China has faced much criticism internationally in recent years for consistently running a large trade (or current account) surplus, but Germany’s trade surpluses have been almost twice as high as China’s in recent years as a percentage of GDP. China has made a conscious effort to reduce its economic dependence on exports, while Germany recorded a record surplus in the first half of 2017. Large and persistent trade surpluses are a problem because the sum of all surpluses has to equal the sum of all deficits. As discussed above, in stable economic periods, the banks in surplus countries can lend to borrowers in deficit countries, maintaining a semblance of balance, but in a crisis this surplus recycling measure comes to a sudden stop. But chronic surpluses also cause an overall decline in demand. The surplus countries are exporting goods but they are spending less than they are making in income.

Keynes called this the paradox of thrift – the phenomenon where when a country’s population saves their money during a downturn this actually causes a fall in aggregate demand, while total savings are not actually increased. Savings must equal investment, so if the level of investment remains the same, the level of savings must also remain the same. People might save a higher proportion of their income, but the only way the level of savings can change is if there is a reduction in the level of income. Stiglitz argues that the global economy today “is in this precise position, with a deficiency of aggregate demand leading to slow growth and 200 million unemployed. This deficiency of demand is the cause of what many call global secular stagnation” (secular meaning long-term stagnation as opposed to cyclical stagnation).

Trade imbalances cause debt crises

Trade imbalances do not only contribute to stagnation. Countries who run deficits must borrow the gap between what they export and what they import, meaning they have to take on more debt and become exposed to the risk of a debt crisis. If the country’s exchange rate can be devalued, then the external imbalance can be gradually reduced as the deficit country’s exports become more competitive on the global market. But inside a currency union, the option of exchange rate adjustment disappears. The main alternative way for a deficit country inside a currency union to regain trade balance is by an ‘internal devaluation’. This is when the nominal exchange rate remains fixed, but the real exchange rate falls as local prices in the deficit country drop, which makes its exports more competitive. (The nominal exchange rate sets the amount of foreign currency that can exchanged for a unit of the domestic currency, while the real exchange rate takes into account local prices and indicates how much goods in the domestic economy can be exchanged for goods in a foreign country.)

In a currency peg system, participating countries are not only prone to experiencing high or long-term unemployment, as they lack the ability to change their exchange rates and interest rates after a shock; they are also very susceptible to debt crises. In the absence of successful internal devaluation, deficit countries with a misaligned exchange rate seeking to finance the gap between their imports and exports rely on capital inflows. If foreign direct investment is not forthcoming then the only option is debt. But if the misalignment in the exchange rate is persistent, then the debt mountain grows until creditors fear it will not be repaid, usually resulting in a sudden stop of credit.

The Irish economy, Spain, Greece and others received huge capital flows after the creation of the euro in 1999, as a result of the elimination of exchange-rate risk. These countries were able to run deficits but also maintain employment and experience growth as a result of the low interest rates they were allowed to borrow at, and the small risk premium on government bonds (the extra amount that was added to the government bonds to compensate for the perceived extra risk associated with lending to that country). Both Ireland and Spain experienced massive housing bubbles based on speculative inflows of capital throughout the 2000s, while neither country imposed any effective measures to cool the heat.

Economist and writer Martin Wolf comments in his book on the financial crisis, The Shifts and the Shocks, that the belief among the Eurozone’s founders was that the problem of trade imbalances would no longer matter in a currency union, “as exchange-rate risks would vanish and payment disequilibria within the area would be smoothly offset by private capital flows”. But “these expectations proved delusional; the sovereign debt crisis in the Eurozone in 2010-12 started as a fully-fledged balance-of-payments crisis… prompted by the accumulation of large payment imbalances between its members and reflecting persistent underlying divergences in prices and costs”. These countries that were running trade deficits based on private and government debt due to the misalignment of their exchange rates then experienced the sudden stop of credit brought about by the global financial crisis, causing creditors to doubt their debts would be repaid. The common currency meant that these countries were forced to turn to the so-called Troika of the European Commission, the ECB and the IMF to be bailed out.

The euro, in this way, is somehow both a domestic and a foreign currency for its members. It is less risky for people, firms and governments to borrow in local currency markets than to borrow in foreign currency. To prevent a debt crisis developing, the government can print more of the local currency to repay creditors. But for Eurozone members, they were borrowing in a supposedly “local” currency that they could not then control. The nature of the Eurozone changed as soon as some members of the monetary union owed other members, Stiglitz argues. “Rather than a partnership of equals striving to adopt policies that benefit each other, the ECB and Eurozone authorities have become credit collection agencies for the lender nations, with Germany particularly influential”. The deficit countries dependent on creditor countries and the ECB are then vulnerable to any and all political and economic demands made by the creditors.

In their study of financial crises over eight centuries, Carmen Reinhart and Kenneth Rogoff identify several key features as having strong correlations with banking crises, all of which applied in the Eurozone. They note that in an analysis of banking crises after 1970, in 18 out of 26 of those studied the financial sector had been liberalised within the previous five years. They also identify a major correlation between removing restrictions on capital mobility and the incidence of banking crises over centuries. “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically”.

A further common feature they identify is that in the lead-up to banking crises there is often what they call a “capital flow bonanza” – a surge of capital inflows of roughly a few per cent of GDP on a multiyear basis, and the tendency to run a large current account deficit. While the liberalisation of the financial sector is by no means limited to the Eurozone, the free movement of capital and persistent trade imbalance problems inherent in the Eurozone, due to its design, make the common currency area prone to crises.

Capital defies gravity

After the signing of the Maastricht Treaty in 1992, the interest rates across the euro area converged towards the low level predominant in Germany. At the same time, in taking steps to lower inflation to the 3 per cent limit required for entry into the common currency, governments implemented deflationary measures that compressed wages. These low interest rates, lower real wages and the removal of all restrictions on capital flows as well as financial deregulation in the euro area combined to cause massive influxes of capital into the peripheral economies, and a massive expansion of both private and government debt in these countries. These trends reached new heights in the years leading up to the crisis, causing worsening trade imbalances and divergence.

From 2003 to 2007, net capital outflows from Germany were on average 45 per cent of its GDP. By comparison, the net capital inflows into Greece over the same period was 37.5 per cent of GDP; in Portugal the net inflow was 36.6 per cent of GDP and in Spain it was 29.1 per cent. A large majority of these inflows came in the form of credit. In the Irish state, house prices doubled in real terms between 1995 and 2005, and then continued to rise. From 2003 until 2007 lending to households in the Irish state expanded at one of the highest rates in the Eurozone, with the exposure by German banks reaching more than US$200 billion.

The once-popular view outlined by Wolf above and expounded by free-market fundamentalists – that trade imbalances would be offset and rectified by private capital flows – proved to be completely false. Instead of playing a balancing and stabilising role in the Eurozone economy, the completely free movement of capital generated massive speculative bubbles, and the abrupt reversal of capital flows from 2008 shows that these capital flows have operated in a pro-cyclical instead of counter-cyclical way. (Pro-cyclical policies exacerbate economic and financial fluctuations, while counter-cyclical policies aim to decrease fluctuations.) If the free movement of capital operated in a counter-cyclical way, as was claimed, then it would flow to weak countries when they were in trouble, instead of doing precisely the opposite.

While there is a single interest rate across the Eurozone, set by the ECB, the risk premium on government bonds and bank debt in different countries means the actual interest rate differs significantly across the common currency area. The perceived risk in lending to a weaker country is reflected in the spread of interest rates. Where economies are viewed as strong (and governments viewed as being capable of bailing out their banks), their banks will benefit from lower interest rates. Weaker countries and their companies have to pay a higher interest rate. During a crisis, capital flees to the ‘safe’ countries’ banks. Since 2008 capital has flowed dramatically from the poorer countries to the rich – not only in the Eurozone but across the global economy – with a large proportion of global capital fleeing to the US as a result of the US government’s perceived ability (and political commitment) to bail out the banks. Inside the Eurozone, the trend has been for capital flight from banks in the periphery to the core, particularly Germany. Stiglitz notes: “Standard economics is based on the gravity principle: money moves from capital-rich countries with low returns to countries with capital shortage. But in Europe under the Euro, capital and labor defy gravity. Money flowed upward”.

The proposed European Deposit Insurance Scheme, the so-called third pillar of the EU’s Banking Union following a single rulebook and single supervision, was dreamt up as a way to reduce this tendency. It is one of the few proposals emanating from the Commission and the leaders of the EU that would could actually effectively reduce divergence in the Eurozone, and reduce the incentive for capital flight from the weak to the strong countries. It could work as a form of institutionalised surplus recycling during a downturn or a period of crisis for the periphery – and for that reason it is being resisted by Germany and has been put on the legislative back-burner. The lack of a common deposit insurance scheme makes the Eurozone “structurally vulnerable” to bank runs according to Wolf.

Betting on default

The so-called sovereign debt crisis saw the global financial crisis shift to inside the euro area, where it still remains, due to the structural flaws in the architecture of the Eurozone. The ‘foreign currency’ nature of the euro – the fact that countries couldn’t create the money they were borrowing in – meant that the belief by investors in the years following the creation of the common currency that all Eurozone government bonds were equal was short-lived. From 2007-2009 the spreads between government bonds in Greece and government bonds in Germany (‘bunds’) increased tenfold up to 2.8 percentage points, with the market giving its ‘verdict’ on the creditworthiness of the Eurozone’s deficit countries. This increased again to a differential of almost 4 percentage points by April 2010, when the Greek government found itself unable to keep funding itself from international money markets. After the Greek default, the markets turned to train their sights on Ireland.

Former Greek Finance Minister Yanis Varoufakis describes this ‘market verdict’ of risk strikingly: “Suddenly [in 2009-2010] hedge funds and banks alike had an epiphany. Why not use some of the public money they had been given [in the mass bank bailouts] to bet that, sooner or later, the strain on public finances (caused by the recession on one hand, which depressed the governments’ tax take, and the huge increase in public debt on the other, for which the banks were themselves responsible) would cause one or more of the Eurozone’s states to default?” The most common way to place these bets was through credit default swaps, which are basically insurance policies that pay out in the case of a default by a third party. As the CDS casino on sovereign debt in the Eurozone grew – instead of this capital being directed towards productive investment or economic recovery – the rising value of CDSs in Greece, Ireland and the other peripheral economies caused the interest rates these countries were forced to pay to rise, pushing them towards the cliff.

Ireland defaulted in December 2010, followed by Portugal and Cyprus. Portugal hadn’t gone through a bubble bursting like Ireland but had experienced a long period of stagnation as a consequence of joining the euro at a very uncompetitive exchange rate that it was then locked into. Cyprus imposed capital controls on euros leaving the country between 2013 and 2015 in fear its partial ‘bail-in’ of deposits would prompt massive capital flight. Iceland had done the same in 2008 but this was the first time capital controls had ever been used in the Eurozone. The Treaty on the Functioning of the EU states that capital controls can only be “justified on grounds of public policy or public security” and that such measures should “not constitute a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments” (Articles 63 and 65), prompting threats of legal action.

The existential crisis of the Eurozone began in 2011 when the CDS bets on Spain and Italy defaulting caused the spreads in the government bonds of these two countries to diverge from bunds by between three and six percentage points, yield rates that had pushed Greece, Ireland and Portugal over the edge. Spain received a recapitalisation package for its banks but it was not a fully-fledged bailout. Italy’s public debt was around four times the amount of the Eurozone rescue fund.

The European Financial Stability Fund (EFSF) was created in 2010 as a temporary vehicle to finance bailouts, and was made permanent in 2013, becoming the European Financial Stability Mechanism (EFSM). The EFSF and EFSM were created to bail out banks, not states. Varoufakis likens the Eurobonds issued by the EFSF to the toxic collateralised debt obligations (CDOs) peddled by Wall Street in the lead-up to the crisis. CDOs were instruments that included ‘slices’ of different bank loans, each with a different level of risk and a different interest rate. The rationale behind CDOs was that by pooling together risky loans with less risky assets, the overall risk profile would be lowered – the CDO would be able to gain a higher credit rating – and they would be more profitable for investors. The “mix was toxic because if one slice within a CDO went bad, that increased the risk of a default by the next slice”. Unbelievably, the same structure and rationale that underpinned the disastrous CDO was used by the EFSF when issuing Eurobonds for lending to the Irish state, and later other countries subject to Troika intervention. Each Eurozone state was required to make a guarantee according to the size of their GDP, and these guarantee from states with wildly diverse credit ratings were then bundled together as bonds. Weaker countries were charged higher interest rates, increasing the pressure on the next weakest state to fall. The EFSM is now a permanent body called the European Stability Mechanism (ESM).

This is an excerpt from the economic discussion document launched by MEP Matt Carthy on October 27, entitled The Future of the Eurozone. Download the full document for a referenced version of Chapter Three, above.

From Bretton-Woods to Maastricht: the creation of the Eurozone

This is an excerpt from the economic discussion document launched by MEP Matt Carthy on October 27, entitled The Future of the Eurozone. Download the full document for a referenced version of Chapter Two, below.

WHEN AN economic downturn affects a country, for whatever reason, a government usually has three key tools to stimulate the economy and restore full employment – lowering interest rates, devaluing the country’s currency (or allowing it to depreciate), or using macroeconomic policy (eg, lowering taxes and boosting public spending). In a currency union, the first two options are dependent on the policy choices imposed by the union’s supranational institutions instead of national bodies.

If all of the economies within the currency union are sufficiently similar in nature, this should theoretically not be a problem. But the economies of the 19 member states of the Eurozone vary widely in their characteristics. At any given moment, the value of the euro vis-à-vis other currencies may be beneficial for some states’ economies but damaging for others. Likewise, the Eurozone-wide interest rates set by the ECB may boost some economies but depress others.

An economic crisis that affects a monetary union comprised of diverse economies will affect different countries in different ways. The designers of the Eurozone were aware of this possibility of “asymmetric shocks” having a different impact on different member states, motivating their development of the so-called convergence criteria. However, for ideological reasons, they chose to focus only on the issue of budgetary divergence, controlling member states’ national debt and deficits. This singular focus on controlling fiscal policy – despite overwhelming evidence that public spending cuts have a contractionary impact during downturns, and with no corresponding focus on the external current account (trade) balance of member states – has caused an increase in inequality and contributed to divergence instead of convergence among the Eurozone’s economies since the introduction of the currency peg.

While left-wing political movements and parties in Europe have focused on campaigning against the policy choices enacted by the EU institutions since the crisis, particularly the imposition of fiscal austerity, there is an urgent need to also examine – and explain – how the very structure of the Eurozone has contributed to inequality and divergence, prolonged and deepened the financial crisis and sovereign debt crisis, and makes future sovereign debt crises inevitable.

The gold standard currency peg

The euro is a currency peg system, which lacks the institutions that have allowed a common currency to work in other parts of the world – ie, in federal states such as the United States, Canada and Australia. Under a peg system, a currency’s value is fixed relative to a commodity, or to another currency.

Before the 20th century the global monetary system was characterised by the gold standard, where the value of different countries’ currencies were pegged to the value of gold, and to each other. The reason there was widespread support for fixing a state’s currency relative to gold was so that governments would not be able to print more money in response to economic conditions to their short-term political benefit. It was intended to deliver price stability. If there was more money pumped into the economy, it would cause prices to rise – causing inflation, reducing the purchasing power of working people, and making it harder for businesses to export their goods. Governments fixed their currencies at a set exchange rate, fixed the rate for exchange of these currencies with gold, and fixed the amount of money they could print with the small and reliable amount of gold entering the economy each year due to new discoveries of the precious metal.

For many decades during the 18th and 19th centuries, the US used a fixed gold standard and at other times relied on fiat money (money backed by a government guarantee instead of being backed by gold) – at times floating, and at times fixed to gold. The scarcity of gold in the late 19th century led to falling prices, deflation and depression in the US; debt became more difficult to repay. During the First World War the Gold Exchange Standard was temporarily suspended. But in spite of these problems and temporary suspensions, the Gold Exchange Standard was still being used by the capitalist countries when the Wall Street stock market crashed in 1929.

This currency peg worsened the Great Depression for the countries that clung to it because it prevented their governments from printing more money to stop banks and businesses failing, and generally to stop a deflationary spiral developing; those who exited the currency peg earlier recovered quicker. The two central lessons of 1929 and governments’ response to it, almost universally accepted by economists today, are that both inflexible exchange rates and austerity measures in response to a sharp downturn will deepen and prolong the crisis.

When a state’s money is flexible it works as a form of shock absorber, but fixed exchange rates remove a key way that economies can adjust to shocks or trade imbalances. Instead of abandoning the gold standard in response to the Great Depression, US President Hoover raised trade tariffs, contributing to a rise in protectionism and a decline in global trade. Some countries who had walked away from the gold standard retaliated by engaging in competitive devaluations of their currencies, in an example of ‘beggar-thy-neighbour’ economic policies. These ‘currency wars’, as they were known, saw countries cause the exchange rate of their currency to fall in relation to other currencies in order to gain a trade advantage – i.e., in order to boost their exports at the expense of other economies. When Franklin Delano Roosevelt won the US presidential elections in 1932, he promptly took the US out of the gold standard, largely ending the common currency system of the era. But the damage had been done, and the slump in the global economy continued until the massive public investment into the “industrial scale carnage” brought about by the Second World War.

The golden era of Bretton-Woods, 1944-1967

The decision to create the euro in 1992 was based on different motivations among its proponents in different countries. But one of the key goals shared by all of the participants was to create a replacement for the Bretton-Woods system that had underpinned the global economy since the end of the Second World War. Bretton-Woods disintegrated in August 1971 with the ‘Nixon Shock’, the announcement by then-US President Richard Nixon that the US was abandoning its commitment to propping up the global economy with the dollar.

The post-war global financial and monetary system was devised and agreed at a three-week conference attended by representatives of 44 Allied countries in the town of Bretton-Woods, New Hampshire, in the US in July 1944 as the Second World War neared its end. It aimed to bring an end to the inter-war global financial volatility that had led to the Great Depression and the collapse of the gold standard, as well as the post-Depression rise of protectionism and competitive currency devaluations.

Bretton Woods

Delegates Mikhail Stepanovich Stepanov (USSR), John Maynard Keynes (Britain) and Vladimir Rybar (Yugoslavia) at the Bretton Woods conference in 1944

The leading figures formulating the agreement were John Maynard Keynes on behalf of the British Treasury, and his more powerful counterpart from the US, Harry Dexter White, representing President Roosevelt. In addition to creating the International Monetary Fund and the International Bank for Reconstruction and Development (which later became known as the World Bank), the agreement also included a commitment to a global fixed-exchange rate system, underpinned by the American dollar, in turn backed by gold. Restrictions were placed on international capital flows in order to prevent currency speculation. The IBRD was to act as an international investment bank with the goal of promoting economic recovery from the war.

As part of the agreement, the US committed to guaranteeing this fixed exchange rate and the convertibility between the dollar and the gold it held, at the price of $35 per ounce of gold. There was a limited option for a country’s exchange rate to be renegotiated if it was clearly impossible to maintain. Within the fixed exchange rate, governments would be required to keep fluctuations within a band of plus or minus one per cent, by buying or selling their own dollar reserves.

The main reason the pre-war gold standard had collapsed was that it was unsustainable for countries to continue to keep such a high value for their currencies when their current account, or trade account, was in a deep deficit. Then, as now, there are balance-of-payment creditor economies with a trade surplus, meaning they export more than they import, and debtor economies with a trade deficit, meaning they import more than they export. A surplus in one country must equal a deficit in another, and every deficit must be financed, usually by borrowing. Economies with a trade surplus find themselves holding large quantities of money in their banks, who lend it to the deficit countries which need to finance their imports. As money is scarce in deficit countries, the interest rate will be higher, meaning it is more profitable for banks to lend to borrowers in these debtor nations. This lending by banks recycles the surpluses – but during a downturn such lending dries up.

The role of the IMF, according to the Bretton-Woods agreement, was to (partially) address this problem for debtor countries by acting as a lender of last resort. White, representing the world’s largest creditor country, scuttled Keynes’s proposals for measures to be taken to adjust trade imbalances on the part of creditor nations, and for a new global currency, the bancor, to be created to underpin an international balance-of-payments clearing mechanism.

However, White and Roosevelt did understand that such a global fixed exchange rate would remove a shock absorber for the global economy and would have the potential to turn a future downturn in the value of the dollar into a global recession. They aimed to establish a mechanism to avoid this. They believed strong regional currencies, backed by heavy industry, needed to be developed in both Europe and Asia. Very quickly after the war was over the US turned to its former foes to act as these strong regional currencies to support the dollar. In March 1947 then-President Harry Truman made a speech calling on the US Congress to intervene in Greece’s civil war by plugging the gap left by the British in providing financial support to pro-monarchist forces fighting Greek communists. The speech marked the arrival of the Truman Doctrine, opening the Cold War era, and it also marked the beginning of a US-backed industrial revival in its former enemies-turned-protégés, West Germany and Japan.

The Marshall Plan, officially known as the European Recovery Program, was launched shortly after the Truman Doctrine was announced and saw the US pump in more than 2 per cent of its national income in aid to western European economies to assist in recovering from the war, but also to ensure their dollarisation. The final factor that ensured Germany’s revival was the role of the US at the London Debt conference of 1953, in which it pressured other European countries to write down, or even write off, Germany’s pre-war debts.

In his book on the changing role of the US in the global economy throughout the 20th century, former Greek finance minister Yanis Varoufakis writes that Keynes’s proposal for an International Currency Union was overruled by Roosevelt’s New Dealers because they had an alternative plan: “The dollar would effectively become the world currency and the US would export goods and capital to Europe and Japan in return for direct investment and political patronage”. The US would run a massive trade surplus with the rest of the world, but it would also use this surplus to directly finance its protégés through aid and investment – meaning that demand for US products would be sustained in these countries. It would also support its key regional currency partners, West Germany and Japan, in their development of trade surpluses with their neighbours at a regional level.

In other words, the US was committed to ensuring it benefited from its position of a strong trade surplus, but made a simultaneous commitment to recycle a large part of its own surplus – in order to bolster other capitalist countries during the Cold War, and to ensure the stability of the new monetary system. The Bretton Woods structure “plainly recognized the asymmetry of the world as it was”, according to US economist and former Federal Reserve chair Paul Volcker, speaking in 1978. “The US, in effect, held an umbrella over the system.”

Nixon Shock: ‘It’s our currency but it’s your problem’

The Bretton Woods era saw two decades of post-war growth and relative stability. But the US had designed this global architecture in the mistaken belief that it would always be in the position of being a trade surplus country. The growth in the industrial capacity of West Germany and Japan in the following decades, combined with a massive rise in US government debt as a result of the costs to the US Treasury of the Vietnam War, started to shake the system by the mid-to-late 1960s. The global trade balance experienced an inversion and the US entered a deficit. Only the US was allowed to print more dollars under the Bretton Woods system, but the fixed exchange rate meant that other currencies pegged to the dollar started to suffer the consequences of US monetary policies. The rising amount of dollars was causing inflation in Europe and elsewhere, and in order to keep the fixed exchange rate in place, European governments had to increase the volume of their own currencies. Currency speculators predicted that the price of gold could not be maintained at $35, and frenetically purchased stocks of gold, worsening the situation.

Germany, France and Britain in particular began to signal their displeasure at the rising quantity of dollars in global markets. From the early 1960s, the Bundesbank resisted printing more Deutschmarks to defend the currency peg. In 1967, the British government under Labour Prime Minister Harold Wilson made an extreme deviation from the one-per-cent fluctuation limit set by Bretton Woods and devalued the pound sterling by 14 per cent. And most dramatically of all, France sent a warship filled with US dollars to New York harbour in early August 1971 with instructions to claim its gold held in the US Federal Reserve and Fort Knox. Britain immediately followed suit – minus the warship – and requested that $3 billion it held in US dollars be redeemed for gold.

Within days, US President Richard Nixon announced the end of gold convertibility on 15 August 1971, in a move that became known as the Nixon Shock and which marked an abrupt collapse of the Bretton Woods system. The US was cutting the rest of the world loose from the dollar zone. The regions that had benefited most from the system, Europe and Japan, would suffer the most from this unceremonious ejection. The US Treasury Secretary, John Connally, famously told a group of European finance ministers that the dollar “is our currency, but it’s your problem”.

Richard Nixon at a news conference

Former US President Richard Nixon

The idea of suspending gold convertibility was proposed to Nixon by Paul Volcker as a kind of ‘Plan B’ in May 1971; Nixon had appointed him as undersecretary of treasury in 1970. At a speech Volcker made in 1978, he reflected: “In the end, the inherent contradictions in the system were too great. With the benefit of hindsight, it would seem that an erosion of the US competitive position was implicit in the post-war arrangements. Europe and later Japan brought its industrial capacity close to US. It took some twenty years, but eventually the US payments position was irreparably undermined.” In the same speech he also said that US policymakers in 1971 believed that “controlled disintegration” of the global economy was a “legitimate goal”. The price of gold and commodities rose drastically and the 1970s were marked by a period of so-called ‘stagflation’ where high unemployment combined with high levels of inflation.

Varoufakis offers a convincing analysis and description of the reversal in global capital flows that followed the Nixon Shock. The US now had both a government deficit and a trade deficit, which policymakers resolved to find ways of making the rest of the world finance. The surpluses generated by the former US beneficiaries, Germany and Japan, needed to be redistributed towards the US somehow. Varoufakis argues that there were “two prerequisites for the reversal of global capital flows, which would see the world’s capital stream into Wall Street for the purpose of financing the expanding US twin deficits” – a rise in the competitiveness of US firms against their competitors in Europe and Japan, and a steep rise in interest rates in the US that would attract capital flows to the US by increasing profitability, but damage other countries’ economies and its own population.

This motivation underpinned the tight constraint of average real wages in the US since the 1970s – which to this day have not regained the real purchasing power they had in 1973 – and unleashed the wave of financial deregulation that was then implemented with enthusiasm by President Ronald Reagan. Capital gravitated towards the dollar in the aftermath of the Nixon Shock, purchasing US Treasury bills and investing in Wall Street. As net capital flows reversed – flowing into the US rather than out of it – the surplus capital of other countries was recycled as the US government and consumers then bought the exports of these same countries. The US played the complete reverse role it had during Bretton Woods but its leading role in recycling trade surpluses in order to maintain a semblance of balance continued. An expansion in the access to credit as a result of capital flows into Wall Street meant working people in the US increasingly went into debt to compensate for their stagnating wages, a pattern that was soon to be replicated in Europe.

The Union is born – as a price-fixing cartel

Understanding the Bretton Woods system, and the reversal in global capital flows that followed its collapse, is crucial to understanding the structures and beliefs underpinning the Eurozone – because the creation of the Eurozone was largely an attempt to recreate the Bretton Woods system.

The European Coal and Steel Community (ECSC), created in 1951, was the first step towards a European Union (EU). In 1950, French foreign minister Robert Schuman proposed that “Franco-German production of coal and steel as a whole be placed under a common High Authority, within the framework of an organisation open to the participation of the other countries of Europe”, which later became the ECSC with the Treaty of Paris in 1951, signed by West Germany, France, Italy, Belgium, the Netherlands and Luxembourg. This “High Authority” of 1951 became known as the European Commission.

Although the leaders of the ECSC participant countries of 1951, and the EU leaders of today, would express horror at such a characterisation, the reality is that the EU began life as a US-devised price-fixing cartel, which “openly and legally controlled prices and output by means of a multinational bureaucracy vested with legal and political powers superseding national parliaments and democratic processes”, according to Varoufakis in his book on the history of the Eurozone and the crisis. France and other countries also aimed to ensure the post-war scarcity of coal and steel did not work to Germany’s advantage. The ECSC fixed the price of coal and steel, and later moved to remove tariffs on coal and steel between members, and then on all goods.

The Treaty of Rome created the European Economic Community (EEC) in 1957. The objections of farmers, particularly in France, to the lowering or elimination of tariffs led to the creation of the Common Agricultural Policy from 1962 onwards, where part of the profits made by the heavy industry cartel were distributed to farmers as subsidies in order to gain their compliance with further economic integration and a customs union. A monetary union was first raised in the Marjolin Memorandum in 1962, authored by the European Commission. This memorandum initiated the first discussion on monetary integration in the EEC and proposed that the customs union should lead to fixed exchange rates between the currencies of its members. But as the Bretton Woods system was working reasonably well at the time to ensure exchange rate stability, there was little follow-up on the proposal in the short term. The first call for a common currency from a political leader came in 1964 – from then-French finance minister (and later President) Valéry Giscard d’Estaing.

A defining moment in the development of a common currency was the publication in 1970 of the Werner Report (to the Council and Commission of the European Communities) “on the realization by stages of economic and monetary union in the Community”. This report, produced against the backdrop of an increasingly strained, and soon to be destroyed, Bretton Woods system, proposed the main elements necessary for monetary union: full and irreversible convertibility of the currencies of the union; elimination of fluctuations in exchange rates; complete freedom of movement of capital; and the centralisation of monetary policy. National currencies could be maintained under the system, the report stated, or a single Community currency could be created, “but psychological and political factors weigh the scale in favour of adopting a single currency that would demonstrate the irreversible nature of the undertaking” (my emphasis).

A snake in a tunnel

The first practical attempt at creating a European currency peg, known as the ‘snake in the tunnel’, began in 1972. The metaphor was grim but apt – the snake was a currency’s exchange rate, and the tunnel was the narrow band in which the rate could fluctuate. Several members of the EEC, plus Britain, Ireland, Denmark and Norway, agreed to limit the margin of fluctuation between their currencies to a difference of no more than 2.25 per cent. It was a clear and open attempt to replicate the Bretton Woods fixed exchange rate regime in order to regain price stability between the European currencies after the collapse of the dollar-backed system the year before.

The Nixon Shock had caused the value of the dollar to fall but the Deutschmark to rise significantly, meaning the price of West Germany’s exports were becoming increasingly expensive. The Deutschmark’s soaring value strained the attempts to manage (or fix) the prices of Europe’s heavy industry and agricultural sectors, the raison dêtre of the EEC. The oil shock – a huge and sudden rise in energy costs – of 1973 forced the deficit countries to emerge from the tunnel. France, Italy, Britain and Ireland could not maintain these fixed exchange rates with the Deutschmark. The only way these deficit countries could maintain such an exchange rate was to increase their interest rates to attract foreign capital and to cut public spending to increase ‘confidence’ that government debt could be repaid, both of which would have significant negative effects on their own populations. By the late 1970s, only the Deutschmark, the Danish Krona and the Benelux countries’ currencies – Belgium, Luxembourg and the Netherlands – were still members of the snake in the tunnel system.

The road to Maastricht

As is the case with all major developments in the history of the EU, the creation of the European Monetary System (EMS) enacted in 1979 was the product of a political compromise between Germany and France. The German and French leaders had announced the creation of the EMS in September 1978. The EMS set a European Currency Unit (ECU) as a “basket” of currencies, and it established an Exchange Rate Mechanism (ERM), which was based on fixed exchange rate margins – but with a degree of variation possible within those margins. There was no official “anchor” currency of the EMS, which lasted for two decades until 1999. But indisputably the Deutschmark was the anchor, and the policies and approach of the system were heavily influenced by the Bundesbank’s phobia of inflation.

There were four key phases of the EMS according to an expert report carried out for the European Commission. The first phase, 1979-1985, included the retention of capital controls by several member countries. The inflation differentials, combined with fixed nominal exchange rates, required “frequent adjustment of the official parities”. The Irish state joined the EMS in 1979, and was required to break the punt’s parity with sterling in order to do so, as sterling – not in the ERM – was appreciating against the ERM currencies. Parity with sterling would have taken the punt outside of the agreed band, so it had to be broken as a condition for Irish entry into the ERM.

During the second phase, 1986-1992, the EMS was referred to by many as the “Deutschmark Area” because members of the system were forced to give up their own monetary policies in order to implement the anti-inflation policies of the Bundesbank and reduce their inflation levels to “German” levels. The so-called Mundell–Fleming trilemma (developed by Robert Mundell and Marcus Fleming, also referred to as the “impossible trinity”) holds that it is impossible for an economy to simultaneously maintain a fixed exchange rate, free movement of capital, and an independent monetary policy. The Commission report agrees: “Owing to the impossible trinity all central banks participating in the ERM had de facto renounced an independent monetary policy”.

Maastricht Treaty draft

Prime Minister Aníbal Cavaco Silva of Portugal; Prime Minister Ruud Lubbers of the Netherlands; Foreign Minister Hans-Dietrich Genscher of Germany; and Jacques Delors, the president of the European Commission toast a draft of the Maastricht Treaty in February 1992 (Jerry Lampen/Reuters)

During this second phase, the Single European Act was passed in 1986, moving towards a single market in the EEC. The then-Commission President, Jacques Delors, established a committee to examine a possible future monetary union, which produced the ‘Delors Report’ in 1989 – the document that led to the Maastricht Treaty of 1992 (endorsed by EEC governments in 1991 but ratified in referenda in Denmark and France in 1992). The Delors Report promoted the view that there was a need for national budget deficit rules, which became the Maastricht convergence criteria, and proposed a new institution, independent of member states, with responsibility for monetary policy – the European Central Bank. In 1990, following the Delors Report’s roadmap, capital controls among members of the EMS were abolished. These developments occurred against the backdrop of the disintegration of the Soviet Union and of German reunification.

From September 1992 until March 1993 the EMS experienced a severe crisis. Some of the members of the EMS were experiencing rising inflation which they were unable to reduce. Currency speculators targeted the over-valued currencies. Fears that voters would reject the Maastricht Treaty on a monetary union, proposed in 1991, contributed to the speculative currency attacks. In June 1992 the Treaty was rejected by 50.7 per cent of Danish voters in a referendum. A similar referendum was held in France, which narrowly endorsed the Maastricht Treaty in September 1992, with 51 per cent of voters supporting it. But massive speculative pressure in the lead-up to the French referendum contributed to the worst crisis in the history of the EMS, which led to the forced ejection of the pound sterling and Italian lira from the ERM, the devaluation of Spain’s peseta, and threats of forced devaluation of other currencies. The fluctuation margin of the EMS was widened to an enormous plus or minus 15 per cent in 1993 in a bid to stop other currencies, particularly the franc, from having to exit. Italy later rejoined the ERM in 1996.

The final phase of the EMS lasted from 1993 until 1999 when the Eurozone was launched by its original 11 member states – Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Greece joined the Eurozone in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in 2014, and finally Lithuania in 2015. An ERM II is in place, supposedly to draw non-Eurozone members of the EU into an alignment of exchange rates, but only the Danish Krona is a member currently. The single market was completed in 1993, allowing the free movement of capital, labour, goods and services, becoming formalised in 1994 by the European Economic Area (EEA) agreement.