Euro crisis primer: a short update
Things have moved on pretty fast since I wrote my first primer on the Euro crisis. I’m not going to repeat the material in there. Rather, I will explain where exactly it is we have gotten to now, because it is pretty impossible to understand if you haven’t been following it closely.
What is the new EU pact all about?
It would require all countries to pass a constitutional amendment severely limiting the government’s ability to run a large budget deficit, and require their budgets to be approved by the European Commission.
Will it help?
The most important thing to grok (new favourite word) is that this whole thing is a complete sideshow to what is actually keeping the Eurozone from falling apart. Indeed, in and of itself it would make the problem worse, because fiscal austerity without monetary expansion will contract the economy. The real action is at the European Central Bank.
What is the ECB doing?
‘Monetary financing’ of government deficits (i.e. direct lending from the central bank to governments) is prohibited by EU law. Now, exactly what technically does or does not count as the monetary financing of government deficits, I have no idea. But safe to say that we won’t get the ECB saying things like ‘We will buy an unlimited number of Italian bonds in order to maintain a yield of under 6%’, even though it is near-universally agreed that if the price of borrowing for the governments of Italy/Spain/Portugal etc. remains at the levels we are currently seeing (which the government does not actually pay until they have to issue new debt or rollover old debt) this will prove unsustainable as and when the governments start actually paying those rates on more and more of their outstanding debt.
However, the ECB is putting in place a mechanism to try and achieve the same thing, but sticking to the letter of the law. What they are doing is saying that they will provide the banks (not the government) with cheap three-year ‘repo’ loans. Now, in ‘wholesale’ bank funding (as opposed to ‘retail’, which is the deposits you, I or the business you work for has) by which means banks finance their lending, one of the key instruments is called a ‘repurchase agreement’ or ‘repo’. Basically, a repo is like a loan against which you offer collateral to the creditor. Kind of conceptually similar to a mortgage, except instead of the loan being secured against a house, it is against a bond or other security you own (and the borrowing terms are considerably shorter, often only a few days or less).
So the ECB is offering these really cheap three-year repos, and so long the ECB accepts sovereign bonds as collateral, they are therefore essentially offering unlimited financing for anyone with a banking license to purchase as much sovereign debt as they want. Here it is, from the horse’s (a.k.a. Sarko’s) mouth:
Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.
Will it work?
Here’s some theory. There are all kinds of European banks that will fail in the event of either a Euro-area sovereign default or a break-up of the Eurozone. Therefore, if this is the only plan on offer to prevent that from happening, then it is rational for you to participate in the plan. However, this poses some collective action problems. If yields get driven down through this plan, then all the banks with tons of sovereign debt on their balance sheets essentially profit from an increase in the value of the loans on their books (the yield and the value of a bond have an inverse relationship – if yield increases, the price of the bond has fallen and vice-versa). So this would be good for banks, but I suspect in the real world what they would all really like is for the yield to get driven down without them having to buy any more bonds. So you wait for the other guys to buy the bonds. Everyone does this. No bonds get bought. Disaster. In reality, the banks aren’t so keen on this idea, and it requires their voluntary participation.
Or does it? Sarkozy’s comment hints at another method – when he said the Italian state will be able to “ask” Italian banks to finance the deficit. There is always the possibility that, one way or another, the government (through special tax loopholes or something far more devious) will be able to coerce domestic banks into loading up their balance sheets with their respective government’s debt. The ECB would make such an arrangement economically possible through the provision of cheap financing, and the governments will try and find a way to make it a political actuality.
What’s the potential downside?
This plan is what I like to call ‘stuffing the fat tails’, by which I mean it would make the ramifications of a crisis much, much worse if it does happen. The more exposure the European banking system has to sovereign debt, the more screwed the banking system is in the event of a default. It only takes one country to mess it up for the whole thing to come tumbling down. You start reading things like this out of Portugal, where politicians are openly saying that their debt is an ‘atomic bomb’ they can use to extract concessions from Germany and France, or listening to this NPR podcast on how the Greeks are threatening to throw in prison the EU technocrat who revised their budget deficit upwards, and you start to realize that the politics of this crisis are just as bad as the economics.
Secondly, the ECB essentially has complete ‘control’ of the situation through its collateral requirements. If they were to impose a ‘haircut’ on certain collateral (which essentially means they wouldn’t lend against the full value of the bond), then this would directly translate into higher borrowing costs for the government. As the excellent Steve Waldman points out:
The ECB would have the power to manufacture fiscal crises for a misbehaving state at will, and with marvelous deniability. Laundered through banks and then through capital markets, ECB actions would be attributed to nameless bond vigilantes rather than unelected technocrats.
This plan is terrible for democracy. Central banks necessarily are institutions where significant power resides, and we are going to have in place a monetary policy where it is all but impossible for the layman to observe the massively consequential decisions of these ‘unelected technocrats’. The ECB will have a policy lever that is devilishly difficult to discern from the outside, and that is just going to make the politics of this situation so much more treacherous than it already is.