Matt Stoller is a fellow at the Roosevelt Institute. You can follow him on twitter at http://www.twitter.com/matthewstoller
As the next INET conference begins in Germany, one topic of conversation is sure to be George Soros’s piece discussing the Eurozone crisis. He points out that the Eurozone has been quietly restructuring its financial arrangements along national lines, ending an era of co-mingled assets and liabilities across national borders. This is something I hadn’t realized, but it presents, as he shows, other dangers.
At the onset of the crisis, the eurozone’s breakup was inconceivable: the assets and liabilities denominated in the common currency were so intermingled that a breakup would cause an uncontrollable meltdown. But, as the crisis has progressed, the eurozone financial system has been progressively reoriented along national lines.
This trend has gathered momentum in recent months. The LTRO enabled Spanish and Italian banks to engage in very profitable and low-risk arbitrage in their own countries’ bonds. And the preferential treatment received by the ECB on its Greek bonds will discourage other investors from holding sovereign debt. If this 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 big problem, Soros says, is Germany. The Bundesbank doesn’t want to be left with credit losses or the remote possibility of inflation, so it is seeking to reduce aggregate demand in Germany.
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.
Soros offers a complex plan which would start with fiscal probity, at least nominally. He proposes auctioning off the ECB’s “seignorage rights”, ie. the profit that the ECB makes by creating Euros. This large pot of money would be used to incentive member states to bring down debt. Soros also distinguishes between debt that will lead to investment returns versus debt that will not. He proposes making the latter the basis for fiscal tightness.
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.
This sounds like a clever way to allow the European elites to pretend like they are engaged in austerity and avoiding money printing, as the European elites engage in fiscal expansion and money printing. the holdup is Germany. As with the ECB printing huge sums of money to buy Eurozone debt through its LTRO program while masking those purchases, it’s about ultimately doing the stability enhancing political embarrassing step while not wounding anyone’s pride.