Month / December 2017

by Admin

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)
by Admin

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
by Admin

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.