Is Merkel Right on Greece?

by MARSHALL AUERBACK

The doom mongers are out in force.  The British Prime Minister, David Cameron, has dramatically stated that European authorities have “just a matter of weeks” to avert economic disaster.  Likewise, the mouthpiece of conventional financial “wisdom”, the Financial Times, argues that 3 steps must be taken immediately to solve the euro crisis:

“First, leaders must take the Greek problem decisively in hand. Aid to Greece should continue, subject to strict conditions. But a debt swap should write down private investors by much more than currently envisaged, in return for longer-maturity Brady-type bonds backed by eurozone collateral….

Second, contagion to other sovereigns must be stopped. The greatest imminent risk is a funding crisis not for small peripheral countries, but for Italy. The eurozone has the means to build a firewall in the form of the European financial stability facility – if the rescue fund obtains the new powers it was promised in July, and if it is leveraged up to several trillion euros. Short of that, the European Central Bank will have to continue buying Italian bonds.

Third, governments in and out of the eurozone must prevent a banking meltdown. This is possible only if the sovereign crisis is brought under control. Bank rescues must not divert resources from protecting sovereign liquidity. The best Europe can do for banks is to subject them to credible stress tests and force more capital on the weakest. France should take note.”

In fact, the crisis has, however haltingly, put Europe’s policy makers on the road to fixing this problem, if politics does not supersede and get in the way.  The solution, however, lies in the hands of the European Central Bank, not political fig-leafs, such as the vaunted European Financial Stability Facility (EFSF).

Letting Greece default won’t end Europe’s crisis and won’t allow Germany and other core nations to brush themselves off and move merrily on their way.  It’s a question if a bailout now is good for Germany and France but not so good for Greece, because if Greece is allowed to default, then their debt goes away. They are agreeing to wipe out their debt and it reduces their payments.  How does that help the core countries, such as Germany or France?

If the ECB continues to fund Greece, and does not allow them to default, then Greece has to continue to make these payments. So the whole dynamic has changed from doing Greece a favor to disciplining Greece by not allowing them to default. The minute Greece defaults, countries such as Germany lose this leverage.  Frau Merkel appears to understand this.

That makes default, arguably, less imminent.

It appears the odds are shifting to the endgame where Greece doesn’t default, where at the end of the day Greece is forced though the austerity measures to run a primary balance or primary surplus, the interest payments will largely wind up with up with the European Central Bank, who is buying Greek debt in the marketplace.  That funds the ECB’s capital base.

Furthermore, the logic that applies to keeping Greece in the eurozone applies to the other nations such as Italy.

It used to be if Germany, France and the others bailed out Greece, and then suddenly they have to bail out Ireland, Portugal, Spain and Italy, they could never have the capacity to do that. In my opinion, it is becoming increasingly understood that there is no limit, no nominal limit to the check that the European Central Bank, as the sole creator of new net euro denominated financial assets, can write.

Plus, Europe can expect no side effects of such Central Bank involvement.

It will not weaken the euro, it will not cause inflation and it will not increase total spending in the region.  Bonds get retired and replaced with reserves, which we know does not lead to inflation either because reserves are not lent out, but exist merely for settlement purposes or interbank lending.  This monetary operation has been confirmed by no less an authority than the BIS – , a paper which explains some of the operational aspects of the monetary system and which mainstream macroeconomics fails to depict in any coherent manner.

The BIS authors say:

The proposition that highlights the inflationary consequences of financing via bank reserves is closely related to the first. If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be. The impact on aggregate demand, and hence inflation, would be very similar regardless of how the central bank chooses to fund balance sheet policy. For example, it is not clear how inflationary pressures could be more pronounced in a banking system that keeps its liquid assets in the form of overnight deposits at the central bank compared to one that holds one-week central bank or treasury bills.

The same would apply to concerns about the “monetisation” of government debt, whereby the central bank purchases government bonds either in the primary or secondary market. Here the issue is whether the financing of government expenditures through the creation of bank reserves, quite apart from the boost to aggregate demand associated with expansionary fiscal policy, would lead to inflation or not.

The use of some of the BIS’s terminology, while conventional among bankers, is  misleading. The central bank does not “finance” government spending by creating bank reserves. Bank reserves are created by public spending which, as we discussed above, present the central bank with some choices depending on its monetary policy stance. The monetary operations conducted by the central bank are not “financing” operations but rather they are correctly understood to be liquidity management operations.

Further, the idea that the central bank can monetize public spending and maintain a positive interest rate target (and pay a support rate below the policy rate) is impossible. If the central bank tried doing this, the competition in the interbank market as banks tried to shed their excess reserves would lead to the central bank losing control of its policy rate. It would have to sell public debt to drain the excess reserves or increase the support rate on excess reserves to the policy rate. You will not get an understanding of this sort of reasoning in any mainstream macroeconomics textbook or research article, but it does address one of the central concerns inherent in the revenue sharing proposal.

At this stage, it appears that the revenue sharing proposal is a bridge too far for European policy makers, who appear wedded to following through on the EFSF proposals, in conjunction with some bond buying backstops provided by the ECB.  But we are at a delicate juncture.  By the ECB continuing to fund Greece, and not allowing Greece to default, but instead to continue to service its debt, the whole dynamic has changed from doing Greece a favor by not allowing Athens to default to disciplining Greece by not allowing the country to default.  And while that’s what the Germans SEEMINGLY haven’t yet figured out, a number of national parliaments have approved the latest package and are quickly moving in the direction where they at least recognize a role for the ECB.

Perhaps the German Chancellor, Angela Merkel, is as well.  Note that she has been most adamant on the particular question of allowing Greece to default or allowing an “orderly restructuring.”

Merkel said that her “entire council” of economic advisers says Greek debt should be restructured, advice that she is not prepared to take. “If we tell a country ‘We cancel half of your debt,’ that’s a great deal,” she said. “Then the next guy will immediately show up and say he wants the same.”

The trick is to support Greece and not permit default without using German taxpayer funds and without weakening the credit capacity of Germany, which the EFSF proposal risks doing.

Hence, the current policy of ECB bond buying, which accomplished all of the above,
is not inflationary, carries austerity as it is prime term and conditionally holds Greece to its obligations.  It also enhances ECB earnings and capital base,and is operationally sustainable, given that the ECB can endlessly credit euros to the national central banks’ own accounts.

I would stress that the ECB’s involvement only deals with the national solvency issue, not with the problem of insufficient aggregate demand. It seems to me that people are continuing to conflate two related but distinct ideas:  solvency and aggregate demand.  They want the ECB to do both, but in fact, the ECB is only required to deal with the solvency issue.  When you do that in a credible way (yes, that means the trillion(s) euro bazooka), then you get the capital markets re-opened and you give countries a better chance to fund themselves again via the capital markets.

Do you think Ontario or British Columbia would be able to fund their health care expenditures or education expenditures if the markets actually thought they were insolvent?  Yet, they can not only do so, but at rates significantly lower than Portugal, even though a province like Ontario has a pretty high public debt to GDP ratio (if you factor in the expenditures for Canadian health care, which is done at the provincial level, via block grants from the Feds).

Deal with the solvency issue and everything else falls into place. It won’t restart economic growth, but it gets you out of the economic cul de sac which has afflicted euro zone policy makers for so long.

At the end of the day, there is no such thing as an “orderly default”.  The Lehman experience should have taught everybody that.  Indeed, it is worth remembering that many of the same voices who now urge an “orderly restructuring” of Greece’s debt were in the forefront of advocating letting Lehman go under.

Consider what happens should Greece default.  What happens then? Will it be possible to establish capital controls while remaining in the Eurozone?  Probably not: While Article VI of the AA of the IMF do allow capital controls, as part of the creation of the ERM in the EMS and then EMU capital controls among EU countries were abolished starting around 1989 and could not be easily be implemented without agreement from other member states since it would be a Treaty violation. Of course, a defaulting government such as Greece may well choose not to play by those rules. It is, by that point, a matter of survival and the avoidance of a failed nation state, and the question is really on whether (and how) the operational technicalities of freezing capital flows can be implemented in a world of shadow banks and encrypted software. The defaulting government, which would probably have a more populist streak than the currently nominally Socialist one, would probably be inclined to tell any enforcement agency or court to just go hang.

Frau Merkel appears to understand this better than most.  For once, the Germans have got it right.

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