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Euro Bond Holders, Beware!

The Insanity of Austerity

by MARSHALL AUERBACK

Austerity during a serious recession is economically insane. It is a pro-cyclical policy that makes the recession more severe. A more severe recession is a mass destroyer of wealth and quality of life. It is pure waste. It is the primary cause of dramatic increases in public deficits and debt. Unemployment reduces tax payments and increases demands for public spending. One cannot decide to end a budgetary deficit during a recession by adopting austerity. Austerity (some combination of cutting government spending and increasing taxes) reduces private and public sector demand. This means that imposing austerity is likely to deepen the recession and can make the national deficit and debt larger. It is analogous to the medical insanity of bleeding patients to cure them of disease – and then bleeding them more because the prior bleeding make them sicker.

So why can’t the Germans see this?  Well, for one thing, because the Germans aren’t experiencing any of this hardship.   In fact, if you look at real retail sales, factory orders, industrial production, total employment and the services PMI (which remains well above 50) it now seems as though the German economy began to resume its economic growth with the commencement of this year.

In many respects, that’s unsurprising. Germany stands in marked contrast to the European periphery. There is no fiscal restriction, domestic interest rates are super low, employment has been expanding rapidly and unemployment stands at a 20 year low. It appears that, having absorbed a trade related and sentiment shock emanating from the European periphery, a domestic demand led expansion has probably resumed. Why, from their perspective, would they wish to impose costs on themselves by bailing out yet another profligate?

By contrast, nearly one in four Spaniards is now unemployed, double digit unemployment is the norm in Ireland, Portugal and Italy and Greece is a dysfunctional mess. The two mainstream, pro-bailout parties, New Democracy and Pasok, only garnered about one-third of votes. They will struggle to form a coalition government – and Greece may soon face more elections. It’s political dysfunction reflects accurately reflects the state of its economy.

Now why should Greece matter? After all, it’s only about 2% of Eurozone GDP and it is already virtually functioning like a barter economy.  The problem, however, is both the contagion effect (can a Greek default be “contained” or will the disease spread inwardly to the core?), and the likely precedent that it sets for other countries.

Okay, it’s a tale of two Europes, but let’s rid ourselves of the notion that the Germans have incurred costs thus far.  They have not.  The whole system has supported the perpetuation of German mercantilism.  It has entrenched their export dominance, both in Europe and globally (as evidenced by their huge current account surplus).  The only “costs” borne so far have been Germany’s workers, who have seen their wages and benefits lose ground by virtue of the Hartz Labour market reforms introduced in the early 2000s.

More recently, the “costs”, such as they are, have been borne by the European Central Bank:  Were the ECB to expand significantly its bond buying program in the secondary market, the notion that the euro would fall is akin to the reasoning that the dollar would collapse if it engaged in QE2. And if what is called quantitative easing was inflationary,Japan would be hyperinflating by now, with the US not far behind.

There is NO sign that the ECB’s buying of euro-denominated government bonds has resulted in any kind of monetary inflation.  Indeed, nothing but deflationary pressures continue to mount in the euro zone, as fiscal austerity continues to dominate policy. The reason there is no inflation from the ECB bond buying is because all it does is shift investor holdings from national govt. debt to ECB balances, which changes nothing in the real economy.

But the question which persistently arises when one advocates a larger institutional role for the ECB is  whether the ECB’s balance sheet would be impaired, and my contention has long been NO,  This is because when the ECB buys the bonds then, by definition, the “profligates” do not default. In fact, as the monopoly provider of the euro, the ECB could easily set the rate at which it buys the bonds (say, 4% for Italy) and eventually it would replenish its capital via the profits it would receive from buying the distressed debt (not that the ECB requires capital in an operational sense; as usual with the eurozone, this is a political issue). At some point, Professor Paul de Grauwe is right:  convinced that the ECBwas serious about resolving the solvency issue, the markets would begin to buy the bonds again and effectively do the ECB’s heavy lifting for them. The bonds would not be trading at these distressed levels if not for the solvency issue,which the ECB can easily address if it chooses to do so.  But this is a question of political will, not operational “sustainability”.

So the grand irony of the day remains this:while there is nothing the ECB can do to cause monetary inflation, even if itwanted to, the ECB, fearing inflation, holds back on the bond buying that would eliminate the national government solvency risk but not halt the deflationarymonetary forces currently in place.

Okay, so if the ECB had simply continued its bond buying program, who would have taken the losses?  Well, presuming the bonds don’t mature at par, no question that a private bank which sells a bond at today’s distressed levels might well take a loss and if the losses are big enough, then banks in this position might well need a recapitalization program.. And in this scenario, Germany too could take a hit, as does every other national government as they use national fiscal resources to recapitalize. And the hit will get bigger the longer the Germans continue to push this crisis to the brink.

But that is a separate issue from the question of whether the bond buying program per se will pose a threat to the ECB’s balance sheet. It will not:  a big income transfer from the private bond holders who sell to the ECB, which can build up its capital base via the profits it makes on purchasing these distressed bonds.  So again, the notion of an ECB being capital constrained is insane.

By contrast, the status quo is a loser for everybody, including Germany, as they are about to discover.  A broader ECB role as lender of last resort (of the kind the Germans are still publicly resisting), along with their unhelpful talk of haircuts and greater private sector losses, actually do MUCH MORE to wreck Germany’s credit position thanthe policy measures which virtually everybody else in Europe is recommending.  Why would any private bondholder with a modicum of fiduciary responsibility buy a European bond, knowing that the rules of the game have changed and that the private buyer could find himself/herself with losses being unilaterally imposed?

In a sense, then,  the Greece fiasco and the resultant electoral backlash is totally a problem of Europe’s own making.  Introducing “hair cuts” was functionally equivalent to imposing a massive tax on private bond holders.  Why, in such circumstances, would any fiduciary now allow any fund manager/pension fund trustee, etc., to buy any euro denominated bonds?

Had the ECB continued to fund Greece via purchases of its bonds,  and didn’t not allow them to default, then Greece would have to continue to make these payments. But the ECB (and the Germans) had this weird idea that somehow continuing their bond buying operation allowed Greece (and other “fiscal deviants”) to avoid their “fiscal responsibilities” (i.e. continued fiscal austerity).

The reality (however misguided), is that the bond buying operations actually provided the ECB with its leverage to force Greece and others to continue their “reforms”. Bond buying by the ECB changed the whole dynamic from doing Greece a favor to disciplining Greece by not allowing them to default and allowing the ECB to collect a significant income stream from the Greeks in the meantime. The minute Greece defaults, this leverage is lost. And then what is to stop the other “problem children” from demanding the same terms?

Consider the following: by virtue of the bond agreement with Greece (now under threat, given the election results), private sector investors took a huge 70% effective hair cut on Greek debt.  This was sanctioned by the EU, despite the fact that the original rules of the currency union stipulated that one bond was as good as another.  So the rules have been unilaterally changed.

It looks great for Greece at one level:  They cut their deficit by 100 billion euro by decree,

by what was called ‘private sector involvement’ which was, functionally, a bond tax.  This was the course of action embraced by EU officialdom, instead of another 100 billion of public sector service cuts and tax hikes on the population.  Yes, there is still austerity to come, but the biggest savings have come by virtue of the fact that the agreement sanctions the “taxation” of the holders of Greek bonds.

And ostensibly nothing ‘bad’ happened, apart from a few banks changing a few numbers down on their books.  Nor did the euro go down or inflation go up or anything else ‘monetary’ go wrong.

Now consider France:  You’re newly elected president Francois Hollande.  You’ve campaigned on a platform opposing more austerity. But you also know the Germans, by virtue of their own healthy economy, have ZERO political appetite to relent on the cause of fiscal austerity.

What to do?  Austerity lite will simply place Hollande in as politically vulnerable a position as his predecessor.  Embracing growth and rejecting the “fiscal stability pact” risks an open rupture with the Germans, a cornerstone of French politics for generations.

But wait: there’s a third option.  No more austerity, just another Greek style bond tax (what will be called more PSI “restructuring”).  After all, if Greece doesn’t have to pay, why do we?  This must be a tempting option for the French.  And if not the “Tricoleur” straight away, what about the Irish, Portuguese or Spanish?

But, so far, not a word from any of them. The silence is deafening.

The risk to bond holders remains very real.

MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Intitute. He can be reached at MAuer1959@aol.com