By Marshall Auerback, a portfolio strategist and hedge fund manager
As several newspapers have recently highlighted, Germany is slowly but surely moving toward a plan to combine much of Europe’s bad debt into a single fund with the idea of paying it off over 25 years. The latter proviso is key, as the bonds are temporary, and therefore compliant with recent decisions by Germany’s Constitutional Court, which has ruled against permanently surrendering Germany’s budget-making power to another entity.
The worsening crisis has led to a sweeping effort to chart a new path forward for the union, one that encompasses fiscal integration, Europe-wide banking supervision, and tighter coordination of economic policies.
German leaders have not provided details of a potential deal — and not every country may be eager to sign on — but it would be likely to mean an expansion of executive power in Brussels over fiscal targets in member states and supervision of their banks, along with Europewide deposit insurance. It would go far beyond what was contemplated for Europe even six months ago.
That’s the good news, right? To be sure, some form of a banking union is necessary, and it probably has to come sooner, rather than later. Given the magnitude of euro deposits which have already flooded into Germany’s banks, a euro area FDIC on its own could well be too little, too late, given the mounting deposit run. We could be looking at trillions of euros of bank deposits in the periphery countries now residing in German banks. Why would these depositors move their money back to, say, Spanish banks at this juncture? Nothing short of a commitment to infinite liquidity provision to banks will do. The Target 2 balances understate the extent of the run, as the ECB somehow finances ELA claims on periphery banks and ECB repos have to some degree financed deposit runs from these banks as well.
Ironically, for all of Germany’s complaints about “bailing out” Europe, if they insist on extracting more pounds of flesh from the already emaciated periphery, the euro zone itself could collapse, and Berlin would be on the hook in more than one way for these lenders of last resort claims as well. More importantly, these claims would be largely unenforceable for Germany if the entire system collapses.
So you need something bigger. Unfortunately, for the most part, Germany is constitutionally incapable of thinking in ‘infinite’ terms. Moreover, a banking union faces another form of resistance from German banks: they are horrified that a real EBA will discover the truth about the black holes within them, notably their Landesbanken.
And there is the question of time. The banking run is still accelerating. We must be getting close to the point where the banks are going to run out of collateral required for Target 2 and ELA loans. Then what happens? Then does the ECB waive all collateral requirements and break the rules or does it act bureaucratically and stick to them? I suspect they’ll do what they are doing for Greece right now and effectively take anything as collateral. But if you get a big “NEIN” all of a sudden, then some big PIIGS bank will not be able to get funding for deposit runs and has to suspend deposit withdrawals. What happens then?
As for the proposal from Germany’s “wise men”, which is now gaining political momentum amongst Berlin’s governing elites, the devil is in the details. If a new “fiscal compact” is part of the deal, it will enshrine an economic impossibility. Leaving aside the point that virtually no country today is compliant with the EU’s Stability and Growth Pact, budget deficits are largely “endogenous” phenomena, which is to say that they are non-discretionary. Slower growth inexorably reduces tax receipts and increases social welfare expenditures (the so-called “automatic stabilisers”). And, as Yanis Varoufakis has noted:
If Spain, Italy, Portugal, Ireland, France, Greece, Germany etc. (i.e. countries with debt well above 60% of GDP) were to reduce their debt by the specified 5% per annum, this would mean that all these nations should turn an average 2.8% primary deficit to something akin to 6% primary surplus. Suppose we could do it (which, of course, we cannot). Were we to succeed in this endeavour, the result would be a very deep recession equal to at least -4.5% in terms of average Eurozone-wide ‘growth’. In a period when a banking crisis is in full swing, the Periphery is in free fall, US growth is tittering of the verge, China is slowing down etc., engineering such a recession via this piece of ‘legislation’ is the macroeconomic equivalent of committing suicide.
This time, it’s not the Greeks, but the Germans, who could well be introducing Trojan Horses into European economic policy. It’s bad economics, stupid politics and unlike the original Greek Trojan horse, might well not bring “victory” to Berlin. So everybody should beware Germans bearing economic “gifts” of this sort, including Mrs. Merkel’s own electorate.