Last Chance to Save the Euro?

After a faulty start to the coronavirus pandemic, the European Union members appear to be getting their act together, as they all appear to have abandoned ruinous slash-and-burn austerity policies (including budget cuts to health care, education and other social services) in order to cope with the onset of a global depression. At least that’s the consensus view, now that both the European Central Bank (ECB) and the European Commission (EC) have temporarily given up the fiscal rulebook and given eurozone members full rein to deploy all available government spending measures to address the pandemic and ultimately help the region’s economy to recover.

The key word here is “temporarily.” Nothing short of a major permanent conceptual leap of imagination is required to preserve the European Monetary Union (EMU). The ECB already underwrites the solvency of the national governments via its bond-buying operations in the secondary market (although it comes with conditions on their government spending attached). Europe’s central bank must therefore move to the next stage, similar to one the United States federal government routinely takes as it allocates a range of funds to citizens across the states. As there is currently no EU fiscal authority, it is the ECB that must take on this quasi-fiscal function, by making annual distributions of funds to the national governments (credited to their accounts at the national central banks) on a per capita basis. That in turn will give the national governments the fiscal latitude to cope with the pandemic and engender long-term economic recovery.

To be sure, it would necessarily take a hard policy backstop for the more rigid financial players in Europe to go along with it; the ECB would have the right to withhold future distributions to members who fail to comply with deficit rules (so that one avoids a race to the bottomwhereby the incentives are totally skewed to spending as much as possible). But it’s easier to withhold something than to take it back, as occurs under the system today. And if these distributions are done on a per capita basis, then no eurozone member could claim they were being penalized or that others were being given unjustifiably favorable treatment. Consider that as the biggest recipient of per capita distributions, Germany might find that particularly appealing. Cost offsets through mergers of EU member national infrastructure, like universities and advanced research institutions, airports, or postal systems, could provide a funding balance, and again strengthen the EU.

Absent something this bold, the existential threat to the euro becomes far more acute. At a minimum, countries under financial duress that the EU should have supported rather than starved two decades ago, such as Italy, will be eyeing the exits as Britain did. “Italexit” becomes a probability, not a mere possibility. In Italy today, as the Financial Times has reported, “there is a rising feeling among even its pro-European elite that the country is being abandoned by its neighbours.” That is important: If Italians begin to lose their emotional attachment to the idea of a broader European community, then the mindset becomes much more like Brexit, where the economic arguments are superseded by something far more profoundly visceral.

On March 26, the European Council (the European Commission’s governing body) released a joint statement from its members that supposedly constitutes Brussels’ Damascene conversion away from fiscal austerity:

“The COVID-19 pandemic constitutes an unprecedented challenge for Europe and the whole world. It requires urgent, decisive, and comprehensive action at the EU, national, regional and local levels. We will do everything that is necessary to protect our citizens and overcome the crisis, while preserving our European values and way of life.”

This statement followed an earlier March 18 pronouncement, where the ECB announced it was taking measures including a pandemic emergency purchase program (PEPP) as well as directing cash transfers at the national levels. The ECB’s role is key because, as sole issuer of currency in the eurozone, it is the only entity that can credibly guarantee the national solvency of all the euro member states.

That’s all fine and well, but as usual with anything relating to the European Union, check the fine print. When you do that, it’s harder to make the case that the commissars of Brussels have done a full-on conversion to Modern Monetary Theory (MMT), as some of the more enthusiastic eurozone advocates have recently suggested, writes economist Dirk Ehnts on Brave New Europe.

For one thing, the arbitrary fiscal rules of the eurozone are being suspended, not eliminated. If anything, the temporary suspension of these rules (the duration of which is still left in the hands of unelected technocrats) reinforces the notion that this represents the ultimate bait and switch risk for countries such as Italy, Spain, or any other eurozone member state that avails itself of limited opportunity to spend whatever it takes to save its respective economy. In reality, lured by the promises of billions of euros to assist their decimated economies, the Mediterranean nations will find themselves trapped like a fox in a foot-clamp the minute the emergency measures are lifted and the countries are forced back into austerity hell.

Let’s take a step back and recall a crucial MMT insight: namely, states that issue a fiat currency that is not backed by any metal or pegged to another currency are in no way constrained in their ability to fund government operations. The money is literally created electronically via computer keystrokes. Hence, these governments are said to be “sovereign” in their own currencies. They can never run out of money, unlike a household or a private business. Nor can they face solvency issues (so long as they do not borrow in a foreign currency). To be sure, sovereign governments do face real resource constraints, but any perceived financing constraints are arbitrary and more apparent than real, given their powers as a monopoly currency issuer.

Of course, the eurozone doesn’t have this feature. The member nation states in the eurozone are “non-sovereign” because they are currency users, not issuers. Only the ECB issues the euro, which means that the individual eurozone countries (like a U.S. state or municipality) can go bankrupt because they are effectively borrowing in a “foreign” currency. To compensate for this enormous potential solvency risk, the members of the monetary union have belatedly conceded (arguably forced on them by former ECB president Mario Draghi after his “whatever it takes” speech) that only the ECB could credibly backstop the national debts of the individual eurozone states via its bond-buying program because only the ECB has unlimited capacity to create euros.

The ECB’s new PEPP program doesn’t attach the usual fiscal conditions (i.e., cuts in government spending in exchange for ECB support), which it had hitherto adopted in earlier bond-buying operations, but the suspension of those conditions is temporary. Other proposed lending programs have included the suggestion of using the €400 billion lending capacity of the European Stability Mechanism (ESM) that was originally established to help recapitalize eurozone banks in difficulty. Dutch and German leaders have been particularly enthusiastic advocates of using this mechanism. The problem here is that access to the ESM also has conditions attached to its lending provisions. And even if these limited conditions are temporarily suspended, they are not eradicated.

In part, these suggestions reflect a wild casting around of any available instrument because thus far the eurozone members cannot make the ultimate conceptual leap to “corona bonds”—yet another attempt to mutualize the European bond markets, in effect creating a supranational eurobond that would not expose individual nation-states to the risk of national insolvency. German and Dutch resistance to joint debt issuance appears insurmountable, as they view it as another form of free-riding by the so-called fiscally profligate economies that would ultimately undermine the northern eurozone members’ pristine credit ratings. There is little appetite there for a “Hamiltonian moment,” whereby the legacy costs of the individual nation-states are assumed by a supranational treasury with expansive fiscal powers.

So, let’s take the example of Italy to illustrate what could happen if Rome were to accept the “assistance” being offered by the European Commission. As a result of increased borrowing to deal with the coronavirus emergency, Italy’s debt-to-GDP ratio could exceed 160 percent, estimates Goldman Sachs. Once the conditions that occasioned the suspension of the eurozone’s rules diminish, pressures will inevitably grow to revert to the status quo ante. Absent continued unconditional ECB support, it is highly unlikely that Italy will be able to continue to refinance its growing debt on the markets anywhere close to prevailing market rates and will find itself experiencing classic debt trap dynamics.

At that point, there are three likely scenarios, as Italian journalist Thomas Fazi writes in a tweet responding to Dirk Ehnts’ recent article on MMT: “(1) ECB accepts to engage in permanent and *unconditional* monetisation of Italy’s debt” (unlikely, as Germany would never sanction it); “(2) as per EU rules, ECB accepts to do the above conditional on Italy entering an ESM austerity programme” (which would consign Italy to decades of economic depression); “(3) Italy leaves the euro” (which would likely lead to a broader breakup, as Italy is the third-largest economy in the eurozone and severance of that link would almost surely destroy the chain).

However, there is also a fourth option that might entail a less fundamentally abrupt institutional change such as the introduction of a “United States of Europe” style treasury: As I wrote 10 years ago, the ECB has historically responded to the European Commission’s Economic and Monetary Union (EMU) “solvency mess by conducting large-scale bond purchases in the secondary market (which, unlike direct purchases of government debt, is not contrary to the Treaty of Maastricht rules [that govern the European Union]) for the debt of the [member states of the EMU].” And, unlike corona bonds, it might encounter less resistance from the likes of Berlin.

Why? As noted earlier, the principal rationale for per capita distributions is that Germany would get the largest distribution of euros from the ECB. Its fundamentally strong position vis a vis other member states wouldn’t change, much as per capita distributions from Washington don’t fundamentally alter the relative economic positions of California versus, say, Arkansas. The distributions would effectively amount to swaps of national debt for reserves, which in turn would immediately adjust national government debt ratios downward (because as an accounting matter, reserves are not counted as national debt). This goal would be to dramatically ease credit tensions and thereby foster normal functioning of the credit markets for the national government debt issues. The governments in turn could use this newfound fiscal relief to pursue fiscal packages that revive their domestic economies (as opposed to using the mechanism for covert bank bailouts).

As I wrote in 2011 and 2012, the trillions of euros’ distribution would end up as reserves on the accounts of the national central banks, they could not be deployed directly for fiscal expenditures (as the Bank for International Settlements notes, bank reserves can only be used for interbank lending, or in settlements with the central bank). But the ECB distributions would enable the national governments’ sovereign bonds to be swapped for reserves. The resultant reduction of public debt on the national government’s balance sheet would in turn give fiscally strained governments additional flexible freedom to borrow and reconstruct their economies (the reciprocal would be reflected as a negative cash balance on the ECB’s balance sheet, but as the issuer of the euro, the ECB does not face solvency issues).

So in essence, the ECB ships money to Italy, Italy uses money to reduce its nominal debt load. That in turn gives Italy more room to borrow and spend on bridges, income support, coronavirus relief, etc. Given the current depression-like conditions, this activity is hardly likely to contribute to additional inflationary pressures either, as much of the spending will ultimately enhance the productive capacity of the affected economies.

Call this process gimmicky, but many forms of public accounting are predicated on similar gimmicks. The U.S. has a “Social Security trust fund” on its balance sheet, but in no way does the government have an actual trust where it stores dollars to pay for one’s Social Security payments. The existence of this trust fund on the U.S. government’s books does not in any way, shape or form enhance Uncle Sam’s ability to meet Social Security commitments.

The resultant flexibility on the size of the fiscal stimulus would in any case trigger growth, which in turn would likely reduce the deficits downward as the economies grow, tax receipts expand and less social welfare provision becomes necessary (it is also worth noting that even before the onset of this pandemic, net of its interest payments, “Italy has been running a fiscal surplus almost continuously since 1992,” according to the Financial Times; the country is hardly a fiscal profligate).

Furthermore, making this distribution an annual event greatly enhances the ability to enforce EU rules, as the penalty for non-compliance can be the withholding of these distributions, which is vastly more effective than the current arrangement of fines and penalties for non-compliance. Historically, fines have proven themselves unenforceable as a practical matter. It is much easier to withhold something than to enforce a take-back.

As I wrote a decade ago, “There are no operational obstacles to the crediting of the accounts of the national governments by the ECB. What would likely be required is approval by the finance ministers.” In theory, there should be “no reason why any would object, as this proposal [which will enhance the SGP] serves to both reduce national debt levels of all member nations and at the same time tighten the control of the European Union over national government finances.”

Ten years ago, when I first made this proposal, it was considered too radical. For years, fears persisted that it would turn the entire eurozone into some bankrupt version of Greece. The concerns of the hyperventilating hyperinflationistas look increasingly less relevant today, especially at a time of a growing international crisis and mounting threats to the existing order. Trillions have been created out of thin air, and there isn’t a Weimar hyperinflation situation to be found anywhere. But what has become increasingly evident to many eurozone countries is that the ongoing use of fiscal conditionality has impinged on their ability to create economic conditions to sustain growth; likewise, national sovereignty has been more apparent than real. Through a series of hastily created programs (usually done in response to a crisis), the leaders of the eurozone have continued to patch up pre-existing institutional flaws, but there are no tangible economic benefits experienced by the vast majority of people.

Assuming of course, that these are flaws. From the European Commission’s perspective, the democratic deficit is the one deficit Brussels’ technocratic elites all seem to like, as it leaves considerable power left in the hands of unelected officials, who can readily override the aspirations and goals of national parliaments. They strengthen the EU’s oligarchic character, centralizing further power in the hands of anti-democratic institutions such as the European Commission, without bringing any concrete benefit for most citizens within the European Union as a whole.

But that’s a politically unsustainable stance amid a global economic depression and lockdown. It’s also bad economic policy, as the evidence relating to the costs that the EU’s austerity policies have built up and a whole generation has been lost. Perhaps the custodians of austerity are calculating that they will be able to continue with an ideology that has created so much misery for so many within Europe (with no corresponding payback). Like Shakespeare’s Macbeth, they are “in blood stepped in so far that should I wade no more, returning were as tedious as go o’er.” But that’s hardly a solid foundation stone to a prosperous and sustainable ever closer European Union. To the contrary, it’s a route to anarchy, more economic chaos and, ultimately, rupture. One hopes therefore that all of the individual member states in the single-currency union do whatever they consider it takes to buttress their overtaxed health systems and enable their economies to recover, and that the hardliners will ultimately experience a Damascene conversion toward rational economic policy-making and nation-building.

This article was produced by Economy for All, a project of the Independent Media Institute.

Marshall Auerback is a market analyst and a research associate at the Levy Institute for Economics at Bard College (  His Twitter hashtag is @Mauerback