By Marshall Auerback
So the ratings agencies have finally followed through on the big threat and downgraded a number of the eurozone’s credit ratings, including France and Austria, both of which have now lost their coveted Triple AAA status. Italy, Portugal and Spain were downgraded a further two notches.
What does this mean and why does it matter?
Investors (often badly informed) use ratings agencies like Fitch, Moody’s and S&P as an indicator of default risk of a country. Countries that receive lower credit ratings are at a disadvantage when they sell bonds because buyers will not pay as much for bonds from a country perceived to be at risk. In effect, ratings agencies are able to bully countries into adopting policies that are friendly to the ratings agencies’ investors. A compliant government often reacts like Pavlov’s dog to the threat or implementation of a downgrade, putting aside the interests of its citizens and starting to introduce discretionary contractions in its net spending, which it does by either raising taxes or cutting spending.
My take is that the ratings downgrade causes a vicious cycle in which countries will end up adopting policies that will put their economies even more at risk than they were already. The reason for this is that in Europe, you’ve got a flawed financial structure that can’t be fixed by austerity measures because it is incapable of dealing with huge external shocks to the demand for goods and services on the part of consumers.
As readers of this blog are well aware, Eurozone countries have faced two types of problems by entering the euro regime that have made them unstable.
First, they have given up their monetary sovereignty by giving up their national currencies and adopting a supranational one. By divorcing the fiscal authority (that which governs a country’s public treasury) from the monetary authority (that which governs the supply of money) member countries have relinquished their public sector’s capacity to provide high levels of employment and output because they are restricted in what they can spend and how they can introduce stimulation in the form of jobs programs or infrastructure projects.
Second, by entering the eurozone, these countries have also agreed to abide by something called the Maastricht Treaty, an agreement which created the European Union and led to the creation of the euro in 1992. This treaty restricts each member country’s budget deficit to only 3 % and debt to 60% of GDP. Therefore, even if a country is able to borrow and finance its deficit spending, like Germany and France, it is not supposed to use fiscal policy above those limits. So countries have resorted to different means to keep their national economies afloat, from trying to foster the export sector, as Germany does, to cooking the books through Wall Street wizardry, like Greece and Italy did. Nations that exceed the limits by the greatest amounts are punished with high interest rates that drive them into a vicious death spiral because deficits rise and lead to further credit downgrades. That is what has happened to Greece, Ireland, Portugal, etc., and now threatens Italy and Spain. Vultures will soon be looking further into the core to places like France.
By contrast, a sovereign government which issued its own currency (such as the US or Canada) could respond to a huge drop in economic activity by expanding fiscal stimulus, or allowing the currency to fall (thereby enhancing growth through exports). On the other hand, eurozone governments ceded their national currencies to the European Central Bank (ECB), the sole entity that can issue unlimited amounts of euros. That is why we’re left with a situation in which the solvency crisis can only be solved by the ECB: It is the only entity which is in a position to buy unlimited quantities of national sovereign bonds in order to ensure that these countries do not continue to pay ruinous rates of interest and suffer further declines in economic activity as a consequence. Fiscal austerity only adds to the problem.
And despite the ongoing hawkish rhetoric from the ECB, there are signs that they are getting it: The LTRO can’t work, as you’re essentially just swapping one liability for another one (albeit more long term in duration, therefore making it better for the banks).
But note the way the ECB balance sheet is expanding: The consolidated assets of the European system of Central Banks is now 4.4 trillion euros or $5.7 trillion. In effect, the consolidated ESCB balance sheet is almost two times that of the Fed and its increase over the last 6 months is almost equal to the entire increase in the Fed’s balance sheet over the last several years.
The figures on the ESCB balance sheet neither includes the recent half trillion euro Long Term Refinancing Option (LTRO) introduced last December, nor further mooted policies in that direction. CLSA has suggested that the speculation on the February 29th LTRO is EUR1trn. Some have suggested even higher numbers.
Bottom line: the system of European Central Banks (ESCB) has been engaged in massive QE and much more is in the pipeline.
With such massive injections of “liquidity” into the European banks, a European Lehman type failure with Lehman’s systemic consequences becomes ever less likely.
Some might argue that the ECB’s balance sheet would be impaired by buying up the government debt of countries in distress. But this is not true, because by definition, the “profligates” cannot default. In fact, as the monopoly provider of the euro, the ECB could easily set the rate at which it buys the bonds (say, 4% for Italy) and eventually it would receive a profit on those loans, which addresses the endless issues about the ECB’s supposed balance sheet risk.
Speaking of which, I have seen so many pieces on this alleged Target 2 problem and I think it’s another misguided panic, much like the hyperinflationists were venting about the dangers of QE in the US last year. And maybe the Germans are guilty about this misguided thinking because they somehow think that because their claims increase on the ECB (which effectively takes on the liabilities of the other NCBs), they are exposed in the event that the ECB goes bust. Why should the ECB go bust?
Look at this another way:
-German net exports to the eurozone entail a surplus in target 2 and thus for the Bundesbank.
-The ECB runs the SMP on the ESCBs balance sheet (ESCB comprises 28 central banks. ECB plus ALL 27 EU central banks, BoE included!).
-In case of euro bond default, these would be losses to the Bundesbank.
This seems to be a reading that goes beyond the "spirit of the Treaty" (as they say), considering that the ECB does not have a statutory minimum capital requirement. It transfers profits to national governments but in times of losses it can only request a capital injection should its capital be depleted.The European Council (which is representative of elected governments) is not compelled to accede to this request.
Hence, the ECB is a perfect balance sheet to warehouse risk since it’s losses need not become a fiscal transfer as it can rebuild its profits via seignorage over a number of years, as I wrote in a recent NEP piece. So there’s no losses to Germany and the Germans are going nuts over nothing. In the end, the "senior creditor" argument explains an unwarranted fear of the Germans.
The Weimar stuff may be for public consumption, but the BUBA default stuff is not any better?
And despite Draghi’s public statements, this time the central banks and governments are committed to move heaven and earth to prevent such a repeat. Hence the $650 bullion three year ECB loan facility and more if it is needed (which doesn’t solve the underlying problem, but defers it for a long time).
The ECB acting this way flies in the face of many of Mario Draghi’s public statements and in light of ongoing German opposition, many think a vast expansion of the ECB’s balance sheet is well nigh politically impossible. But democracies don’t “do” deflation very well. Contrary to conventional wisdsom, it’s the eurozone’s currently ruinous fiscal austerity policies that are truly politically unsustainable. They will not only cause more economic and social misery, but they undermine much of the residual political support for the common currency. Consider the case of Austria, which lost its AAA rating along with France. The leader of Austria’s far right FPÖ, H.C. Strache, has embraced an explicitly anti-euro position, and he is gaining political traction in the polls, as is Marine Le Pen, leader of the National Front in France, where Presidential elections are due to be held in 3 months’ time.. Both oppose the euro — to be fair — for the right reasons. The only problem is that the rest of their policies are a dystopian nightmare. Similarly, in an interview with German daily Die Welt (and the choice and location of publication is extremely important), the new head of Italy’s “technocratic” government, Mario Monti, lamented that despite Italy’s considerable fiscal austerity measures, they aren’t seeing lower interest rates. Fiscal austerity in the midst of a recession is bad policy at the best of times, but Monti did what he was told and now he’s got nothing to show for it. Has he become the victim of a German “Italian Job” (all you Michael Caine fans will know what I’m talking about here).
Monti has pointed to the threat that Italian sentiment is finely balanced. Make the wrong decision now, he said, and the populists will take control. With that in mind, observe that the Italian Social Democrat party commented last week that it would like to see Italy leave EMU.
Are we about to re-enact the 1930s? Perhaps the ECB is finally realising that the stakes are too high, even in the midst of their Bundesbank-like Germanic posturing.
- Why Investors will buy Italian bonds after ECB monetisation from Nov 2011
- On the ECB’s Long-Term Refinancing Operation and 2012 macro ideas for investors from Dec 2011
About Marshall Auerback
Marshall Auerback, has 29 years experience in the investment management business, serving as a global portfolio strategist for Madison Street Partners, LLC, a Denver based hedge fund. He also has also worked as an economic consultant to PIMCO, the world’s largest bond fund management group. He is a Fellow at the Economists for Peace and Security, a Research Associate at the Levy Institute, and a non-executive director of Pinetree Capital in Toronto, Ontario, Canada.
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