George Soros has been a busy man the last few days. Appearing at the INET Conference a number of times and penning detailed articles for the FT (and here at Project Syndicate) describing the terrible situation in which Europe finds itself – and furthermore offering a potential solution. Critically, he opines, the European crisis is complex since it is a vicious circle of competing crises: sovereign debt, balance of payments, banking, competitiveness, and structurally defective non-optimal currency union. The fact is ‘we are very far from equilibrium…of the Maastricht criteria’ with his very clear insight that the massive gap, or cognitive dissonance, between the ‘official authorities’ hope and the outside world who see how abnormal the situation is, is troublesome at best. Analogizing the periphery countries as third-world countries that are heavily indebted in a foreign currency (that they cannot print), his initial conclusion ends with the blunt statement that “the euro has really broken down” and the ensuing discussion of just what this means from both an economic and socially devastating perspective: the destruction of the common market and the European Union and how this will end in acrimonious recriminations with worse conflicts between European states than before.
However, he offers some hope and a potential solution to the fact that these nations have implicitly handed their ‘seignorage rights’ to the ECB, in the potential for a balance between fiscal austerity and deflation (or at minimum new rules that would remove to a greater extent the vicious circle of the fiscal compact as deflationary debt trap). The punchline being the creation of an SPV that ‘owns the ECB’s seignorage rights – estimated to be worth $2-3 trillion’ that could explicitly be used to acquire bonds without violating the Lisbon Treaty. The sad truth of this admittedly smart financial engineering (pretend austerity and optically no money printing when exactly that is occurring) is that the Bundesbank will never agree to it (as implicitly it ends up at the foot of the German taxpayer to a greater or lesser extent) even though, as he concludes, the future of the Euro is a political one and thus “beyond the Bundesbank’s competence to decide.” Just as we noted back in December and reiterated here as likely given TARGET-2 imbalances (also confirmed by Deutsche Bank), Soros points out that the Bundesbank has “started taking measures to limit the losses that it would sustain in case of a
breakup.” and this creates a self-fulfilling prophecy that markets are reflecting.
A must-watch harsh reality check on Europe and a man trying to find answers when the authorities remain blind to the endgame…
NEW YORK – Far from abating, the euro crisis has taken a turn for the worse in recent months.The European Central Bank managed to relieve an incipient credit crunch through its long-term refinancing operation (LTRO)…
The fundamental problems have not been resolved; indeed, the gap between creditor and debtor countries continues to widen. The crisis has entered what may be a less volatile but potentially more lethal phase.
At the onset of the crisis, the eurozone’s breakup was inconceivable…
If [ECB encumbrance] continues for a few more years, a eurozone breakup would become possible without a meltdown – the omelet could be unscrambled – but it would leave the creditor countries’ central banks holding large, difficult-to-enforce claims against the debtor countries’ central banks.
The Bundesbank has become aware of the danger. It is now engaged in a campaign against the indefinite expansion of the money supply, and it has started taking measures to limit the losses that it would sustain in case of a breakup. This is creating a self-fulfilling prophecy: once the Bundesbank starts guarding against a breakup, everybody will have to do the same. Markets are beginning to reflect this.
The Bundesbank is also tightening credit at home. This would be the right policy if Germany was a freestanding country, but the eurozone’s heavily indebted member countries badly need stronger demand from Germany to avoid recession. Without it, the eurozone’s “fiscal compact,” agreed last December, cannot possibly work. The heavily indebted countries will either fail to implement the necessary measures, or, if they do, they will fail to meet their targets, as collapsing growth drives down budget revenues. Either way, debt ratios will rise, and the competitiveness gap with Germany will widen.
Whether or not the euro endures, Europe faces a long period of economic stagnation or worse. Other countries have gone through similar experiences. Latin American countries suffered a lost decade after 1982, and Japan has been stagnating for a quarter-century; both have survived. But the European Union is not a country, and it is unlikely to survive. The deflationary debt trap is threatening to destroy a still-incomplete political union.
The only way to escape the trap is to recognize that current policies are counterproductive and change course. I cannot propose a cut-and-dried plan, but three observations stand out. First, the rules governing the eurozone have failed and need to be radically revised. Defending a status quo that is unworkable only makes matters worse. Second, the current situation is highly anomalous, and some exceptional measures are needed to restore normalcy. Finally, the new rules must allow for financial markets’ inherent instability.
Most importantly, some extraordinary measures need to be invented to bring conditions back to normal. The EU’s fiscal charter compels member states annually to reduce their public debt by one-twentieth of the amount by which it exceeds 60% of GDP. I propose that member states jointly reward good behavior by taking over that obligation.
The member states have transferred their seignorage rights to the ECB, and the ECB is currently earning about €25 billion ($32.7 billion) annually. The seignorage rights have been estimated by Willem Buiter of Citibank and Huw Pill of Goldman Sachs, working independently, to be worth between €2-3 trillion, because they will yield more as the economy grows and interest rates return to normal. A Special Purpose Vehicle (SPV) owning the rights could use the ECB to finance the cost of acquiring the bonds without violating Article 123 of the Lisbon Treaty.
Should a country violate the fiscal compact, it would wholly or partly forfeit its reward and be obliged to pay interest on the debt owned by the SPV. That would impose tough fiscal discipline, indeed.
By rewarding good behavior, the fiscal compact would no longer constitute a deflationary debt trap, and the outlook would radically improve. In addition, to narrow the competitiveness gap, all members should be able to refinance their existing debt at the same interest rate. But that would require greater fiscal integration, so it would have to be phased in gradually.
The Bundesbank will never accept these proposals, but the European authorities ought to take them seriously. The future of Europe is a political issue, and thus is beyond the Bundesbank’s competence to decide.
And incidentally speaking of the Bundesbank, recall back in December Zero Hedge’s view on the endgame via “Has The Imploding European Shadow Banking System Forced The Bundesbank To Prepare For Plan B?” where we said, focusing on the TARGET2 issue :
the Bundesbank, if disambiguated from the ECB, where it currently is accountable for funding a major portion of deficit nations’ funding deficiency, would regain its status as the world highest quality monetary institution. And going back to the beginning, it is the Bundesbank which is effectively depleting “good money” in exchange for “bad” either in the form of undervalued collateral through the repo markets, or soon to be devalued fiat.
Here one has to keep in mind the primary prerogative of the Buba – keep inflation low. If that means detaching from a failing currency, or halting asset-liability matching in which it hands out good money in exchange for worthless assets, so be it.
Which is why another interpretation of the ECB’s proposal is not to bring the ECB as a lender of only resort closer to the peripheral, deficit nations, but to commence proceedings for severing the umbilical cord of the Bundesbank with a Eurozone which is doomed in all but the most optimistic eyes. Bringing us to our question: for anyone wondering what the future of the Eurozone is, should they merely observe what steps the German central bank is stealthily starting to take. Because if indeed the Buba wants to have as little as possible with Europe, what does that mean for the EUR, and for Europe itself?
Four months later, here comes Deutsche Bank’s Thomas Mayer with “Why the Buba Wants To Exit.” Excerpts (full link):
Why the Buba wants to exit
Recent data illustrate the above analysis. For the last year, more than three quarters of ECB loans have gone to banks in Southern European countries and Ireland. More recently, the liberal use of long-term ECB loans in France and Germany has temporarily reduced the share of the GIIPS countries in ECB lending. At the same time, the positions of national central banks in the euro area’s interbank payment system Target 2 show that these loans have helped to fund cumulated balance-of-payments deficits of the non triple-A rated countries versus the triple-A rated countries (Germany, Netherlands, Finland and Luxembourg). The latter country group has lent the former so far more than EUR900bn (Table 1). As long as the liberal supply of ECB funds to the countries with balance-of-payments deficits continues, the Target positions are likely to increase further. Until recently, liquidity flowing from the balance-of-payments deficit countries to surplus countries tended to be re-deposited at the national central banks of the latter. However, as Chart 2 for the case of Germany shows, liquidity has started to flow out into the non-financial sector (with the German banking sector turning again into a net debtor to the Bundesbank).
The case for exiting
By mid-year governments are scheduled to have completed the new EMU governance structure, including a new treaty on fiscal policy and a permanent crisis management mechanism. According to the governments, this is it. No further measures are presently being contemplated. Against this background, the recent suggestion by the President of the Bundesbank that the ECB begin a gradual exit from its non-standard measures and thus to raise pressure for balance sheet adjustment seems only logical. As of mid-year it is up to governments to restructure or unwind insolvent banks and to the permanent crisis management mechanism to provide adjustment funding to governments and banks, when needed. The present dual and contradictory support scheme—conditional lending under IMF/EU adjustment programmes and unconditional, unlimited lending under the ECB’s special refi operations—ought to be reconciled and merged into a unified support scheme.
It is, of course, possible that the new EMU architecture will not be able to deal with the remaining adjustment challenges. Even after its recent extension to some EUR800bn, the combined resources of the EFSF / ESM are unlikely to be sufficient to fund Italy or Spain in case markets shut down for these countries. But this would require further repair of the EMU architecture and could not justify an open-ended involvement of the ECB in propping up insolvent banks or governments. As we have argued before, we would favour the transformation of the ESM into a true European Monetary Fund with the mandate to implement and fund adjustment programmes for countries, facilitate debt restructuring for insolvent countries, and deal with systemically relevant banking sector problems. As part of a unified support scheme, this EMF would have access to ECB credit as a measure of last resort to deal with systemically risky liquidity crunches, whereby the final decision to extend credit would lie with the ECB.
The ECB’s non-standard monetary policy measures were taken to deal with problems in the financial sector and not to extend monetary policy easing beyond interest rate cuts, as was the case in the US and UK. Hence, these measures should logically only be continued as long as they promote efficient adjustment in the financial sector. The present regime of fixed rate, full allocation refinancing operations tends to ease the adjustment burden in the financial sector of countries with internal and external deficits and to shift the costs of rebalancing the balance of payments of EMU member countries to balance of payments surplus countries. Relative prices are adjusted by pushing prices in the surplus countries up without exerting downward pressure on prices in the deficit countries. With a new fiscal pact and permanent crisis management mechanism in place as of the middle of this year, it is now up to governments to engineer a more symmetrical adjustment. Should the new EMU architecture prove insufficient, governments should take the necessary additional steps and refrain from enlisting the ECB in making up for these deficiencies, in our view.
Which, alas won’t happen, and the Bundesbank will be even more on the hook. Just as we further elaborated in “Explaining The European €2.5 Trillion Liquidity Catch 22 Closed Loop.” So yeah: tin foil hat conspiracy and all that jazz.