There were a number of great presentations, including lectures by two financial experts who I consider to be among the best speakers today, Frank Veneroso (of Veneroso Associates) and Paul McCulley (the recently retired brains behind PIMCO). Like many of the presenters at the seminar, both of them addressed the growing crisis in Euroland.
Frank admitted that he had only recently recognized that the Euro system was “designed to fail”. As readers of this blog know, those of us who adopt Modern Money Theory (MMT) have argued since the start that the fatal flaw was the attempted separation of fiscal policy from a sovereign currency. When individual nations like Greece or Italy joined the EMU, they adopted a “foreign” currency—the Euro—but retained responsibility for their nation’s fiscal policy.
For the past decade, many critics have focused on the policy of the ECB—arguing that monetary policy was too tight. Others have argued that the Maastricht Criteria were too tight. While both of these criticisms had some validity, they always missed the main problem: Italy had become the equivalent of a Louisiana but without the benefit of an Uncle Sam. So the problem really was not that nations gave up “monetary” policy (interest rate setting) or that they agreed to overly tight constraints on budget deficits and debts. In reality, as I argued previously on this blog, the Maastricht criteria were too loose. And ECB monetary policy actually was no tighter than Fed policy (on average over the past decade). Nor does monetary policy matter much (see the excellent post by Stephanie Kelton today: http://neweconomicperspectives.org/2012/06/can-monetary-policy-do-more.html.
Given the set-up, individual Euronations would inevitably face two problems.
If a deep recession hit, their budgets would automatically move to deep deficits. The problem would not be the Maastricht Criteria (since, after all, almost all Euronations persistently violated those criteria) but rather that markets would raise risk premia on their debt—which would cause interest rates to explode in a manner that would increase deficits further in a vicious cycle. With no “Uncle Sam” to come to their rescue, they’d have to rely on the charity of the ECB to keep their interest rates down. Good luck with that! With the ECB operating under the thumb of the Bundesbank, that was always a fool’s bet.
The second, much greater, problem was that individual nations had become responsible for their own banking systems. But there was no hope that they’d be able to bail them out without sinking their governments. Again, this was by design of the Euro system: there was no Uncle Sam in Brussels to come to the rescue of the governments burdened by debt run-up by private banks that could easily be orders of magnitude greater than total government spending or taxing.
One of the goals of integration was to free up labor and capital flows, removing barriers so that factors of production could cross borders. Indeed, that was a primary reason for adopting the single currency. Whether or not that was a good idea—and whether or not it worked—is another matter. What is important for our discussion today is that it enabled banks to buy assets and issue liabilities all over Euroland. And boy-oh-boy did they do that.
The icing on the cake was the deregulation and desupervision of banking contained in the Basle Accords. That allowed banks to undertake the same sort of crazy schemes that Wall Street’s banks pursued.
That is, of course, what got Irish banks into heaps of trouble as they ramped up lending across Europe, growing their liabilities to multiples of Irish GDP. Then, when their bets went bad, the Irish government had to bail them out, boosting fiscal deficits and government debt to uncharted territory.
Again, this was a design feature of the EMU and the EU more generally: free the banks so that they can blow up, then blow up the government budgets as they try to rescue their banks. (It was not just Euro banks that did it of course; think Iceland and the UK.)
In reality, of course, the Irish bail-out was really designed to save the banks of the center nations—not the periphery. Ireland fell on the sword in perhaps the greatest act of charity ever seen in the history of humanity as it protected German and French and English banks from losses on their lending to Irish banks. Unlike the potato famine, this catastrophe was entirely produced by the Irish government’s policy of taking on the bank debt.
But more important to the current crisis in Euroland was the ability of bank depositors to costlessly shift Euro deposits from one bank to another anywhere in the EMU. This is enabled by the so-called Target 2 facility. Any depositor of—let us say—a Spanish bank can move deposits to a German bank. I won’t go deeply into the details in this particular blog, but such a shift requires that the central bank of Spain obtain reserves that get credited to the central bank of Germany. If deposits tend to flow from the periphery nations, their central banks go ever more deeply in hock to the ECB to obtain reserves that accumulate in the account of the Bundesbank.
Euroland is now in the midst of a massive run on periphery bank deposits. If you think about it, anyone who still has a Euro deposit in any bank other than a German bank is either a philanthropist or a fool. Moving deposits to German banks is a sure bet: if Germany leaves the EMU depositors will get appreciating Marks, and if Germany remains in the EMU depositors have the safest Euro deposits available.
Why take a risk that Italy or Spain or Greece will leave the EMU, default on Euro-denominated deposits, and redenominate them into a depreciating currency?
Frank Veneroso believes that the ongoing run on Spanish banks, alone, could amount to 2 trillion euros flowing to German banks. The run should accelerate in coming days, as periphery depositors decide to be neither fools nor philanthropists.
And if that does happen, Target 2 ensures that the ECB will be stuck with trillions of euros of uncollectible debts due to all the reserves it has been lending to central banks that have to finance the run to German banks. It all essentially comes down to an inadequately designed “reflux” system.
The future lifespan of the EMU can now be measured in days, unless Euroland immediately adopts unlimited deposit insurance for all Euro deposits in all EMU banks.
But Ms. Merkel has declared this would violate the German constitution. Deposit insurance would place an essentially unlimited liability on the ECB, which would be insolvent if Spain or Italy were to leave the EMU. And with no Uncle Sam standing behind the ECB, Germany would get the bill. That’s a bill Germany will not accept. Hence, no deposit insurance and hence no future for the EMU.
Paul McCulley provided essentially the same assessment, although I think he’s been onboard with MMT for quite a while.
As always, Paul provided some nice framing.
As readers of this blog know, MMTers like to begin the analysis by consolidating the central bank and treasury because it simplifies the analysis. We then argue that this consolidated “government” spends by crediting accounts (“keystrokes”) and taxes by debiting them. Deficit spending thus leads to net credits of bank deposits as well as bank reserves. Bond sales offer an interest-earning alternative to zero (or low) earning reserves.
We do this not because we ignore the “internal” operations that go on between the central bank and treasury, nor are we ignorant of various operating constraints put on the treasury. We know, for example, that most modern treasuries cannot sell bonds directly to their central banks; and we know that the treasury must have “money in its account” at its central bank before it can cut a check; and we know that the US Congress in its infinite wisdom has imposed a debt limit on the US Treasury. But the consolidation of the Fed and Treasury balance sheets is a simplification that gives us a place to start the analysis. Then we add the bells and whistles.
Paul gets that. He pointed out that no one objects to consolidating the balance sheets of husband and wife. The “family balance sheet” is consolidated in the same way that we consolidate the “government balance sheet”. Sure, the wife owes the husband and the husband owes the wife. And before the wife can spend on those Gucci shoes, she’s probably got to jump through some pre-approved hoops. Paul called these hoops “pre-nuptials”. The central bank and treasury have entered into a variety of pre-nuptials, some of which are probably a good idea.
But by mutual agreement, they can be changed. And both the US Treasury as well as the US Fed are “creatures of Congress”, subject to the laws drafted by elected representatives and signed by the president. If the pre-nuptials get in the way of good public policy, they can be eliminated.
Paul closed his talk with an appeal. He noted that MMT gets all this right. It foresaw the Global Financial Collapse. It predicted the current crisis of Euroland, providing the correct prognosis of the fatal flaws of divorcing fiscal policy from currency sovereignty. And it predicted that the first serious financial crisis would create an insurmountable EMU crisis. Only a thorough reformation to unify fiscal policy and currency sovereignty will save the project of integration.
So, Paul asked, why not simply declare victory? Be magnanimous toward all those who got it wrong. No need to rub their faces in their mistakes and the mess they’ve made. Welcome them aboard.
We’re all MMTers now!
For more details on the MMT approach, order my new book, which should be out in August:
Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems, by L. Randall Wray , Palgrave Macmillan, August 2012; Order your copy at http://www.palgrave.com/products/title.aspx?pid=548208
As you all know, the GLF has been on hiatus. It’s back. I’ll continue this thread next week. Thanks for your patience.