The EU Is Facing Gigantic Questions About Its Future That Are Hidden in Obscure Bank Policy Decisions

By Marshall Auerback, a market analyst and commentator. Produced by Economy for All, a project of the Independent Media Institute

After dramatically lowering its growth forecast for the European Union (EU), the European Central Bank president, Mario Draghi, announced that the ECB would keep interest rate rises on hold for at least another year, as well as resuming the bond-buying operations for the national debt of the members of the Eurozone (EZ). The latter was particularly surprising, as it marked an abrupt reversal of a policy that was discontinued at the end of last year.

But the about-face points to both the ongoing structural weaknesses inherent in the single currency union, as well mounting political and economic challenges to the EU as a whole. These are the consequences of a wide-ranging and long-term neoliberal collection of policies, which have produced rising populism of a distinctly neofascist hue, growing intra-political tension even between traditional allies, and a lost generation due to double-digit unemployment, to cite some of the most egregious examples. And, of course, there is Brexit, much like Banquo’s ghost, hovering over everything and exacerbating the threat to the European integration project.

It’s easy to understand why the European Central Bank reversed itself on quantitative easing. The surprise was that it thought it could stop in the first place. As the sole issuer of the euro, the ECB is the only entity that can credibly backstop the national debt of the EZ countries. Eliminate that backstop, and the risk of solvency raises its ugly head again (and with it, the prospect of much higher borrowing costs across the continent and a potential financial crisis).

But simply buying bonds is insufficient; the prevailing austerity bias that governs single currency membership has to be eliminated as well. The former addresses the solvency issue, the latter the problem of insufficient aggregate demand in the EZ, the source of anemic growth and high unemployment. We therefore need both: ECB bond buying, coupled with a tolerance for much larger national fiscal deficits.

Longer term, the Eurozone desperately requires bigger institutional change, such as the creation of a mechanism that allows for the mutualization of debt, much as Alexander Hamilton helped to establish for the United States of America, when it migrated from a system featuring a weak national authority under the Articles of Confederation (where the 13 colonies were more like 13 individual nation-states and Congress was a mere arbiter among them) to a more robust federal structure replete with a strong centralized system of debt management and taxation. In the short term, however, only the ECB can adequately accommodate this via larger bond purchases minus the conditionality of austerity.

Unfortunately, additional fiscal policy stimulus has long been the rock on which European-wide policy consensus has foundered, a paralysis that has done much to stoke growing populist anti-EU sentiment across the continent. And debt mutualization is something that Berlin in particular has strongly resisted, seeing it as yet another attempt to secure backdoor bailouts for what it perceives to be the profligate Mediterranean countries.

Of course, it’s easier to resist such policies at a time when your own economy is booming and close to full employment. Perhaps Germany would be more amenable to a change of policy once the vulnerabilities of its own export-dependent growth model are further exposed? Alternatively, Germany might come to appreciate the risks it now faces as the EZ’s largest creditor if debt repudiation was actually on the cards from a country like, say, Italy?

It’s also worth noting that even Hamilton’s debt mutualization proposals met huge resistance from a number of individual states (notably Virginia, which was the Germany of the 13 original colonies in terms of its relative fiscal health/economic strength). It took the combination of a revolutionary war, external threats from the British empire, and the possibility of bankruptcy and debt repudiation to create the political conditions necessary to induce acceptance of Hamilton’s proposals. Might similarly grave existential political threats, combined with the prospect of a serious global recession be enough to change the political calculus in the EZ as a whole? It’s not an optimal way to induce change, but sometimes it takes the political/economic equivalent of an earthquake or flood to establish substantial foundational reform. Certainly, that seems to have been the case for the EU so far.

The technical term describing the ECB’s bond-buying operations is “Longer-Term Refinancing Operations” (LTRO), more popularly known as “quantitative easing” (QE). This is a policy that involves the central bank buying bonds (or other bank assets) in exchange for electronic deposits made by the monetary authority into the commercial banking system, which in econ-speak means “crediting bank reserves.” QE, in various forms, has long been deployed by a number of key central banks—notably the U.S. Federal Reserve, the Bank of Japan and the European Central Bank—in theory as a means of reviving demand for credit, but in practice simply inciting Keynes’ “animal spirits” to revive capital markets and thereby promote more robust economic activity in response to that revival.

The tangible economic impacts/benefits of QE have long been debated. But as far as the specific European situation goes, the ECB’s decision to involve itself directly in ongoing purchases of national debt has been crucial in terms of coping with the institutional quirk that lies at the heart of the single currency—namely, the absence of a supranational “United States of Europe” fiscal authority. There is already a degree of centralization in the EU (e.g., the source of origin rules, trade agreements, a common agricultural policy). But its parliament in Strasbourg still has comparatively limited fiscal powers. By divorcing fiscal and monetary authorities, the members of the single currency union hobbled their respective national governments’ ability to sustain full employment because their ability to spend has been circumscribed by virtue of the fact that they are effectively borrowing in a foreign currency. That means that unlike a fully sovereign government, such as the United States, which has the ability to create unlimited dollars, Eurozone countries are more like American states or cities, which are limited in their ability to spend by taxation and bond revenues. More importantly, as currency “users,” rather than “issuers,” these countries can go broke, much like what happened to the city of Detroit some six years ago. In that sense, they are “non-sovereign” states.

As the economists Yeva Nersisyan and L. Randall Wray have outlined, this distinction between “sovereign” and “non-sovereign” applies to all members of the Eurozone—to Germany and France, as much as Portugal or Italy. The Eurozone members have lost their sovereignty precisely because they cannot create euros without limit to sustain economic growth, and are therefore dependent on the markets to provide ongoing borrowing support absent help from the ECB. The Eurozone, therefore, is the one place where the “bond vigilantes” actually do exert real influence. The credit spreads (i.e., the differential in borrowing costs) that have arisen between German national debt on the one hand, and the Mediterranean countries on the other, reflect the market’s collective judgment in regard to the creditworthiness of each individual member of the single currency union.

The minute that the ECB and the various national central banks (particularly the German Bundesbank) began calling attention to the fiscal unsustainability of certain countries’ policies (notably Greece, where the country’s fiscal sleight of hand for a time masked the true magnitude of its borrowing requirements), the solvency issue of the euro moved front and center.

As Greece fessed up to cooking its books, markets began to take a less sanguine view of many of the other Eurozone countries’ creditworthiness, picking them off, one by one: Greece, Ireland, Portugal, Spain, Italy. And at that stage, the central bank had not yet initiated any QE. As a result, credit spreads began to blow out as the markets quickly intuited that (contrary to the stated intentions of the founders of the common currency) one national bond was not as good as another. The whole European Monetary Union began to look like nothing more than a giant Wall Street-confected collateralized debt obligation, with the lower quality tranches in the bottom tiers infecting the creditworthiness of the entire single currency zone. That is, until the ECB got directly involved after Draghi’s famous “whatever it takes” speech.

The only problem was that this promise of bond buying was conditionally predicated on each country implementing “sound” fiscal policies—i.e., they were biased toward austerity to keep the budgets balanced, which meant that solvency came at the expense of ongoing anemic economic growth in many of the member states (notably, Greece, Italy, Spain, and France). In terms of stoking growth, therefore, this process was as effective as drilling a hole in one end of a canoe while bailing out water from the other. Draghi’s commitment “worked” to the extent that borrowing rates for all of the Eurozone countries came tumbling down and the spreads among the various countries began to converge. But the austerity conditionality has ensured that growth has remained sub-standard in many EZ countries, particularly in regard to unemployment.

By the time that the ECB had wound down QE three months ago (after four years of substantial bond buying), the economic backdrop had recovered somewhat (although the aggregate data had been disproportionately inflated by Germany’s strong export performance in response to improved global economic conditions). Countries like Greece and Italy, however, never really emerged out of the growth doldrums. And, as Draghi noted last week, overall economic conditions in the EZ are rapidly deteriorating again, even in Germany where export growth has started to dissipate. Draghi’s reversal on QE has to be seen in the context of a downward revision to GDP growth from 1.7 percent to rise 1.1 percent this year. This dire forecast was accompanied by a downward GDP revision in 2020 from 1.7 percent to 1.6 percent.

Perhaps we should be grateful that Mr. Draghi did not wait for the markets to test his intentions when he first announced the end of the bond-buying operations last December. Had the markets called the ECB’s bluff, and the central bank failed to respond, the whole solvency question would have come back with a vengeance, a crisis being the likely result. Still, the fact that the ECB still had to reverse itself a mere three months later suggests that the underlying fragilities inherent in the EZ are still very extreme. The whole structure is beginning to look like a house of cards without the ability to fiat.

And the political timing couldn’t have been worse. We are now supposedly in the home stretch as far as the Brexit divorce negotiations go. The official “D-Day” is March 29, but there are still huge Parliamentary splits in the UK, in regard to the form that Brexit will ultimately take or, indeed, whether it should still take place at all, given what is on offer. It is therefore becoming increasingly likely that the UK will be forced to apply for an extension of the Article 50 period, especially given that the enabling legislation has not yet been completed. Moreover, this extension could well be for quite a long time. If, in the interim, the Eurozone begins to look like a house on fire, it will no doubt provide succor to the hardline Brexiters, who want to leave the EU as soon as possible, deal or no deal. By the same token, a robust policy response by Brussels (more bond buying and greater toleration of fiscal expansion across the continent to improve the growth outlook) could well shift the policy dynamics in the opposite direction (possibly even toward the retention of the status quo in regard to Britain’s existing relationship with the European Union). Any shift away from the EZ’s prevailing neoliberal economics would certainly accelerate the ongoing shift of the UK’s Labour Party away from a “hard Brexit.”

Given the history, the latter outcome seems less likely, but the situation is more fraught than usual, which might beget a less ham-handed response. The EU’s most tangible progress toward required solutions have tended to occur when the existential threats facing it are most acute. Recall that there was adamant opposition to the ECB’s bond-buying operations when it was first publicly mooted, and yet today such practices are firmly entrenched (even the German representative on the ECB concurred in a unanimous decision to restart QE). Earlier, it was the French farmers who (literally) created roadblocks to a common agricultural policy until the lure of additional money swept them aside. And today, a common defense policy, indeed a European army, looks to be in the cards, even though that was considered a political non-starter a few years ago. So the halting steps toward increasing federalization are coming, even though this “two steps forward, one step back” progress is obscured by temporary opposition, which is usually bribed into compliance. Paradoxically, the prevailing austerity heightens the appreciation for the cash allocation from Brussels, as well as making it more politically palatable for the austerity-biased countries, to relent, when such austerity pushes the EZ toward breaking point. The point is that the resolve and strength of the engine driving the European project is often underestimated.

If ever there was a time for the Brussels mandarins to change course, it’s now. The odds still favor the EU facing a likely British divorce, and there are impending EU elections in May. It would be an unhealthy outcome to have those elections taking place in the context of still rancorous negotiations with the UK (or an economically destabilizing No Deal split), along with a backdrop of rapidly declining economic growth, which could further fuel the rise of anti-EU parties across the continent (especially in Italy, where fascism originally flowered). Any one of these factors on its own could represent danger. Taken in aggregate, they represent a profound existential threat. The hope is that this threat will spur the EU to do the right thing.

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  1. DavidEG

    “The technical term describing the ECB’s bond-buying operations is “Longer-Term Refinancing Operations” (LTRO), more popularly known as “quantitative easing” (QE).”

    This is wrong. Direct securities purchases carried out by the ECB on secondary markets go under the name of Asset Purchase Programmes. These were phased out in Dec 2018 (except for the reinvestment of maturing assets). LTROs are meant to ease financing constraints for banks (italian ones continue to be in a particularly bad place), which now can simply roll over the debts originated in the previous rounds of LTROs.

    1. Sanxi

      Not the only thing that is wrong with this post “notably Virginia, which was the Germany of the 13 original colonies in terms of its relative fiscal health/economic strength”, no it wasn’t by a long shot. It fact after the revolution never was. Also, as Pres. Jackson whacked the bank, what’s the point? QE as used in the US was to buy (mostly), fed member’s banks junk, nothing from the fifty States, so in ‘EZ’, the central bank buying from its’ underlying nation-states ‘bind’, seems more like MMT than anything. Really argument by babble.

      1. David J.

        Perhaps Auerback could have expressed it better, but I think I get his gist. Virginia did have a fairly strong economy relative to many of the other states in the 1780s/90s. And, when considering what Auerback suggests in the paragraph just above the quote you cite, it’s easy to see that he is trying to draw a parallel between Germany’s importance in the current context to Virginia’s importance back then.

        “Perhaps Germany would be more amenable to a change of policy once the vulnerabilities of its own export-dependent growth model are further exposed? Alternatively, Germany might come to appreciate the risks it now faces as the EZ’s largest creditor if debt repudiation was actually on the cards from a country like, say, Italy?”

        Virginia’s economic strength was also export dependent in the late 18th century. Tobacco mostly. And at that time, political power within the state resided mostly in the Tidewater where the large plantations were. For folks who have some interest in this aspect. And while Virginia was not a creditor in it’s region as Germany is now in Europe, there were risks (at least risks perceived by a goodly portion of Virginians who had political clout) in shifting from a loose confederation to a more centralized national government.

        For those interested, reading about the Virginia state convention on adopting the Constitution is fascinating. It was a close vote to adopt, roughly a half dozen or so votes iirc. The later debates about debt assumption and setting up the First National Bank are in some respects just a continuation of these competing views, at least insofar as Virginia is concerned.

        And, btw, the bank that Jackson “whacked” was the Second National Bank, not the First.

        In any case, I think I get what Auerback is trying to say here, but he could have said it better.

        1. Marshall Auerback

          Probably correct. My point was that the States that stood to lose from assumption of the debt by the national gov’t were against it; states that hoped to gain were in favour of it; and states whose interests were not greatly affected either way were indifferent. Virginia was in the anti camp. Similar in economic weight to Virginia during the late 18th century US, Germany makes up roughly one fourth of the eurozone’s population and contributes al-most 30 percent to the eurozone’s overall GDP. As in the case of Virginia, Germany sees itself in a position of being exposed to debt assumption claims; Not a particularly complicated historic analogy, but perhaps could have been phrased more elegantly

  2. technicality freak

    Just two technical corrections on this article:
    – The ECB’s announcement is not a volte-face. The ECB just communicated that it will continue for longer its current stance, which consists of rolling over its holdings of bonds (bought under the several programmes in place, namely central government bonds, covered bonds, non-financial corporate bonds and ABS).
    – The purchase programmes are not to be confounded with the TLTROs. The latter are similar to regular refinancing operations (reverse repos) with banks, only with much longer maturities for each operation (compared to normal central bank refinancing) and some pricing features aimed at incentivising credit expansion by the recipients. The ECB has announced that more TLTROs will be launched, extending the outstanding ones.
    All in all, the ECB has signalled that the end of QE is not as near as earlier communicated, but it’s not an abrupt policy reversal.

  3. Sound of the Suburbs

    Richard Koo knew what would happen in the West after 2008, as had been studying it in Japan since the 1990s.

    The sequence of events:

    1) Debt fuelled boom
    2) Minsky moment
    3) Balance sheet recession

    The nature of the money supply is like a dark void for nearly all policymakers, they know nothing about it.

    Richard Koo had worked in the Federal Reserve Bank of New York and so he did know, and was in a position to work out what was going wrong in Japan.

    Bank loans create money and repayments to banks destroy money.

    The money supply ≈ public debt + private debt

    Japan has been deleveraging from their debt fuelled boom of the 1980s ever since. As the Japanese have been paying down debt, the private debt component of the money supply has been going down ever since. They have compensated by increasing Government borrowing to compensate, maintain the money supply and avoid debt deflation.

    The IMF predicted Greek GDP would have recovered by 2015 with austerity.
    By 2015 Greek GDP was down 27% and still falling.

    The money supply ≈ public debt + private debt

    The “private debt” component was going down with deleveraging from a debt fuelled boom. The Troika then wrecked the Greek economy by cutting the “public debt” component and pushed the economy into debt deflation.

    The Euro-zone policymakers don’t seem to understand where the money supply comes from and insist on austerity and balanced budgets that are damaging Europe’s economies that are on the edge of debt deflation.

    In the balance sheet recession QE cannot enter the real economy due to a lack of borrowers.
    QE increases bank reserves that have to be borrowed to get into the real economy and Richard Koo’s video shows the enormous bank reserves built up by the FED, BoE, ECB and BoJ that can’t get into the real economy.

    The central bank’s are trying to use a tool that won’t work in a balance sheet recession as Japan has already discovered (Richard Koo doesn’t know what Kuroda is doing with his QE to infinity).

    Dropping interest rates also doesn’t work as people are looking to deleverage, not take on new loans no matter how low the interest rates.

    The West did before 2008, what Japan did in the 1980s, but refuses to learn the lessons that have already been learnt.

  4. chuck roast

    Thank you Marshall, but NC habituaes have read about this ad nauseaum. Yesterday’s Links provided a refreshing proscription to this description by Yanis Varoufakis including a what amounts to a democratic take-over of the ECB. What could be more refreshing?

    The Democracy in Europe Movement 2025 (DiEM25) is proposing a comprehensive plan for a New Deal for Europe. Included, among other heterodox proposals, is a “...long term, public digital-payment platforms would form a managed system of country-specific euros that work like an International Clearing Union, a modern version of John Maynard Keynes’s 1944 vision for the Bretton Woods system.” This amounts to disturbing the graves of Henry Morgenthau, Jr. and Marriner Eccles, and this is a good thing.

    Please see…

    1. Susan the Other

      But compare Stiglitz in today’s links saying our political system is washed up and Europe will have to lead the way. Somehow the EU, with all it’s problems on sovereignty, has managed to maintain a system that controls the things we simply ignored, which became our ruin. They simply do regulation better. Maybe that’s why they thought they could regulate banking without sovereignty… well there’s always an Achille’s heel. Anyway, it’s nice that there is a confluence of questions about “obscure banking” quirks, MMT/social spending solutions, and a crossroads using capitalism, socialism, and MMT. It’s getting interesting. It’s almost fun to watch how we humans synthesize our solutions. (As opposed to some slip ups like Brexit which seems to be the complete opposite of synthesis – more like just smash and grab it.)

  5. ewmayer

    “It’s easy to understand why the European Central Bank reversed itself on quantitative easing.”

    Yes, indeed, why continue such a fabulous policy which has done so much to strengthen the real economies of the EU member states, right? Oh, wait … from a recent Wolf Richter piece on this subject:

    The real worry is the economy in the Eurozone – despite the fabulous stimulus the ECB has heaped on it for years, including a brutal negative-interest-rate policy and massive QE that has inflated the ECB’s balance sheet to over 40% of Eurozone GDP (by comparison, the Fed’s balance sheet is down to 19.5% of US GDP).

    Wolf’s URL provides an apt summary of the “given an initiative which is a proven failure in terms of achieving it aims and rather has simply massively distorted the debt markets, central bankers invariably double down on it” dynamic at work here. When your only tool is a hammer – here in form of NIRP and fiat-money-crtl-p-ing – every problem looks like a nail.

  6. Seamus Padraig

    Why is it that whenever the voters complain about the system, it’s now labelled ‘fascism’ or ‘neofascism’? The voters in Italy, for example, had some (to my way of thinking) very good and legitimate complaints regarding the economy and the EU, and they voted how they felt. What’s wrong with that? When did majority-rule become ‘fascism’, while letting the big banks loot the West become ‘democracy in action’? I really wish Auerback (and others) would eschew this questionable terminology.

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