Despite our regular reports highlighting some of the challenges facing those tasked with managing the euro, public concern about government debt levels appears to have subsided to its lowest level since 2008. This low level of public awareness is due to a combination of factors; the natural desire of the ECB and Eurozone finance ministers to downplay these challenges whilst extolling modest Eurozone economic growth, secondly mainstream media’s obsession with Brexit, and thirdly the lack of visible ‘shocks’ to the system since the last Greek crisis almost 3 years ago. Furthermore, 2017 was the first year that all of the Eurozone countries’ budget deficits were less than 3% of GDP and thus more or less in compliance with the 1999 Stability and Growth Pact upper limit of 3%.
However, despite the popularity of the “Eurozone Recovery” story, readers should not doubt that Europe’s political and institutional leaders are far from complacent. These individuals are aware of the challenges and openly debate policies to be implemented before the next crisis erupts.
Perverse Incentives for Governments to Borrow from the Central Banking System
Since 2012, the ECB has played a leading role in keeping the main problems from visibly surfacing, but most of the policies debated recognise that the ECB cannot resolve the deep-seated problems without major steps towards centralisation of powers.
As Philipp Bagus points out, the ECB’s policies have ironically enhanced such structural problems and exposed the ‘misconstruction’ of the euro. The reason why the crisis is invisible to the public is that Eurozone governments no longer have to concern themselves with public markets for their debt instruments. When Country A wishes to borrow further, it issues bonds which are bought by banks in Country A, who are incentivised by the generous regulatory treatment of such bonds combined with an albeit modest return that is nowadays regarded as risk-free. The buying banks simply pledge the bonds to their national central bank, which is permitted to issue fresh central bank money against them. The result of this liquidity creation is that the spending power of euros should gradually weaken throughout the entire Eurozone, rather than predominantly in Country A, creating perverse incentives for other countries to behave in a similar fashion.
Without More Formal Federalization, What Can the ECB Achieve?
In March, we wrote about the next likely major monetary policy measure, Sovereign Bond Backed Securities “SBBS” . By way of brief recap, this policy would entail the creation of a new public institution, probably managed by the ECB, which would purchase debt securities of Eurozone governments and issue senior, mezzanine and junior bonds – SBBS – to finance their purchase. Of the many benefits set out in the detailed report now being reviewed by all 19 states, one is to break the link (the “doom loop”) between domestic banks and their national governments, which is the essence of the funding mechanism summarised in the paragraph above. However, this very arrangement for governments is probably the single most important reason why the crisis has disappeared from public view. On May 25th, the Eurozone Finance Ministers (“ECOFIN”) meet and the SBBS project is on the agenda. If the proposal is greenlighted, our view is that either it will have little impact on the doom loop, or, if it breaks it, new problems could be unleashed that may spark a new and visible crisis by upsetting the comfortable status quo of non-market based government funding.
The Federalization Policy Choices
If reliance on technical ECB monetary policies is to be supported by major political actions, Bagus sees only two options; either a) implement serious new rules regarding government spending and deficit levels, or b) formalise a Transfer Union within the Eurozone. To these we would add a third, complete centralization, creating a single legal entity out of the 19 Eurozone states. This third option would facilitate a transfer union, in the way that national governments support needy regions.
As for the first option, introducing new rules without federalization will be challenging, given the present stand-offs between Europe’s institutions and some poorer Eastern European countries, who complain that rule enforcement is so discretionary that they are being singled out and disadvantaged.
European Commission President Jean-Claude Juncker has boasted about being flexible regarding rule enforcement. According to Der Spiegel journalists, Peter Mueller and Christopher Schult, “All are equal, but some are more equal than others is Juncker’s operating principle, which annoys all the countries that feel at a disadvantage within the EU, chief among them the smaller Eastern European states.” The authors observe that of the 120 breaches of the Stability and Growth Pact Rules over 20 years, the only country against whom any sanction was imposed was Hungary, in 2012.
Given the evidence of non-enforcement of financial rules, attempts to compel countries like Hungary, Poland and the Czech Republic to comply with non-financial rules have created tensions. Poland has also been criticised by the European Commission for flouting judgements against it by the European Court of Justice, and last July the Commission initiated a sanctioning process which could lead to suspension of its EU voting rights. More likely are financial penalties in the form of suspension of its ability to receive EU Structural Funds. These penalties could be introduced under the new EU wide funding package incepting in 2020, and are being advocated by wealthy Germany’s European Commissioner, Günter Oettinger.
Perhaps a Single European State?
A popular, if cynical view, is that prominent leaders such as Chancellor Merkel and President Macron may be quite happy with the emergence of this split between Eurozone countries and non-euro Eastern Europe member states. Brexit will reduce funding into the EU, and major changes will be required which could be presented to the non-euro countries on a “take it or leave it basis”, since euro adoption by all is a key tenet of federalization.
Given President Macron’s speeches calling for banking, capital markets and fiscal union, buttressed by a European Monetary Fund and Finance Ministry with budget setting powers, he may be not far from the view of Bob Lyddon, who sees the only serious policy choice to save the euro as completion of a Single European State, meaning:
1. All EU member states adopting the Euro
2. A single Bank Deposit Compensation Scheme
3. Unification of the Eurosystem into a legal person
4. Harmonisation of the forms of central bank money
5. Mutualisation of government debt
Lyddon’s view is that in a number of areas the severity of the Eurozone’s government debt and banking problems are underappreciated. For example, the European Investment Bank (“EIB”) and the European Fund for Strategic Investments (“EFSI”) which it manages, have advanced since 2015 about euros 200 bn of loans for primarily infrastructure projects. However, these projects are not ones that truly create the foundation for economic growth but should be regarded as borrow and spend exercises, the effect of which is to boost GDP at the time of disbursement, whilst saddling member states with debt service charges over several years into the future.
Secondly, the banking systems of the periphery countries remain hopelessly bogged down with bad loans and the magical solution of securitising non-performing loans (“NPLs”) has fizzled out as private sector buyers have become disenchanted with the terms offered. In addition to the NPL burden, there is increasing awareness of the much larger problem of ‘zombie loans’ – loans kept alive by the present very low interest rates set by the ECB. Thirdly, negotiations around the frequently discussed European Bank Deposit Insurance Scheme appear to be stalled, although this is another item for the May 25th ECOFIN agenda.
The only realistic prospect of addressing these problems is the removal of powers from national governments. If not, perverse incentives will continue to play out, resulting in pressure on the euro’s continuing existence.
In our view, Bob Lyddon’s thinking may well appeal to Europe’s leaders. There is little point in further tweaking ECB rules against a background of rising interest rates and clamours for the reduction of ECB support. The principles of debt mutualisation have already been accepted in the way the EU budget and EIB funding work. If a major centralization plan is announced, many non-Eurozone countries might decide that they would be better off in an enlarged Eurozone.
The Single European State plan would of course involve significant cessation of sovereignty. There is unlikely to be federalisation without a crisis. However, until more concrete centralization occurs, national governments will likely frustrate and rule game, in particular preventing the closure and resolution of any significant bank. Therefore, all minds are on the next eruption, the cost of which may be full federalization and maybe even debt mutualisation.