The PIIGS Problem: Maginot Line Economics
Monday, 04/12/2010 - 12:10 pm by Marshall Auerback | 13 Comments
Marshall Auerback warns that Germany’s obsession with a defense against the external threat of inflation is blinding them to the real risks facing Europe.
The Maginot Line, named after French Minister of Defense André Maginot, was a line of defenses which France constructed along its borders with Germany and Italy after suffering appalling damage and casualties during World War I. The French thought they were now protected from a repeat, and believed the defenses impenetrable.
Chatting to a number of German participants at last week’s Institute for New Economic Thinking (INET) conference, we couldn’t help getting a sense of the economic parallel in regard to Germany’s deep resistance to greater fiscal expansion as means of dealing with the problem of the “PIIGS“.
The Problem:
Germany’s fiscal deficit fetishism is largely a product of that country’s own hyperinflation experience during the Weimar Republic. As deeply ingrained as that trauma remains in the German psyche, it is now taking on an almost hysterically irrational quality as evidenced by the latest “rescue package” for Greece. Its EMU “partners”, led by Greece and soon to be followed by Portugal, Spain, Ireland and Italy, are increasingly being forced to embrace Germanic-style hair shirt economics, because the obvious fiscal response is constrained via self-imposed rules inherent in the rules governing the European Monetary Union. These rules are regarded, almost to a man, as “sound economics” by Germany’s policy makers and the vast majority of its citizens (if one is to measure this via the national polls, which continue to indicate visceral hostility to “bailouts” for “lazy Greek scroungers and tax dodgers”). We wonder if they’ll still be feeling that way if the contagion extends to Berlin and Paris.
Historians all know how effective the Maginot Line ultimately proved for the French in terms of defending a German occupation of their country during the Second World War: the Germans were able to avoid a direct assault on the Maginot Line by violating the neutrality of Belgium, Luxemburg and the Netherlands, whilst the Luftwaffe simply flew over it.
Likewise, we think Germany’s “Weimar 2.0″ phobia is based on similarly flawed “Maginot Line” thinking, thereby generating a correspondingly ineffectual response to the EMU crisis. It’s becoming a story of intellectual hubris, defending “good economics”, Germanic-style, over common sense.
Judging from the market’s reaction to the 45m euro rescue package of Greece, it appears that the EMU and, by extension, the euro, have dodged a bullet for now. But the PIIGS problems remain. The terms and conditions include IMF ‘austerity’ measures, which will act to slow the economy of Greece and the entire EU — which is already dangerously weak to the point of promoting higher budget deficits through low tax revenues and high transfer payments. All of which serves to further weaken the creditworthiness of all the member nations.
It also increases the euro debts of the other contributing nations because they are being forced to contribute to this funding package for Greece. The implication of the same type of ‘rescue’ for the larger euro nations is not pretty. Expect much higher levels of stress for the remaining euro member nations presumed to be ’strong’ as the same kind of forced austerity appears in store for other “violators” of the Maastricht Convergence Criteria. Think about Spain, which now has 20% unemployment, or Ireland, which has a classic Iceland problem, given that the liabilities of its banking system vastly exceed the country’s overall GDP.
The underlying assumption of the rescue package is not sound. The stronger nations still think by offering a big enough “guarantee” the markets will take up the slack and finance Greece for them. But the markets now want to see the cash and, more importantly, they want a firm demonstration that the funding guarantees provided will help to sustain the ability of nations like Greece to service its debt without turning the nation into an industrial wasteland. The markets no longer believe in a “contingent liability” model, which is something akin to indicating that you have a rich relative who can help you out if needed. The EMU’s “rich relative” has already indicated that this is verboten, but it has denied Greece and the other PIIGS nations the means to grow adequately to service debt going forward.
The Prognosis:
The euro should therefore fundamentally remain on the weak side after a temporary bout of short-covering, as the high levels of euro national government deficits are adding the non government sectors’ holding of euro denominated financial assets. And the austerity measures are likely to increase euro government deficits and thereby exacerbates potential national insolvency problems amongst the euro zone nations.
The common Germanic retort to this line of thinking is that a default in, say, California, would no more threaten the viability of the dollar than a Greek default would endanger the euro. Perhaps, although the Lehman experience should have taught us all that the negative externalities of such an event can seldom be determined in advance, given the opacity of today’s funding mechanisms. Additionally, the United States of America is an existing NATIONAL fiscal authority which can respond to the growing problem of state insolvency via dollar creation and corresponding revenue sharing with the states. No such comparable fiscal entity yet exists in the euro zone.
Although we have hitherto characterized Greece as the EMU’s “Lehman” problem, the rescue package announced on Monday makes us that think that the better parallel for Greece might well be Bear Stearns. Bear’s “rescue” in March 2008, initially looked like it enabled the global financial markets to avert a growing crisis in the asset backed securities markets. What it did in reality was kick the can down the road, as the underlying structural problems which created the crisis in the first place remained unresolved. The credit crisis that began in August 2007 involved failure of both the liquidity and the solvency risk systems. The consequent freeze-up arose because the subsequent bankruptcy of Lehman and collapse of AIG destroyed the markets’ expectations (built up by years of bailouts) of their being an ultimate market maker, which would always be able to deal in these securitized instruments.
By the same token, the creation of a common currency via monetary union has created market expectations that one country’s paper is as good as another, which explains why, for so many years, “fiscally profligate” nations such as Italy were able to borrow at Germanic level interest rates. But the decision a few months ago by the European Central Bank to block a basic “repo” function — namely, the purchases of a number of European commercial banks of Greek government debt and exchanging this debt via repos with the ECB for German and French government paper is what appears to have initially triggered the Greek crisis and raised issues of Athens’s potential insolvency.
From what we understand, the cessation of this repo function was largely done at the behest of the Germans, who saw this activity as a kind of “back door monetization” which would lead inevitably to inflation. This, despite the fact that the entire euro zone is characterized by huge unemployment , high output gaps, and collapsing domestic consumption. All of this at the core is being driven by Germany’s pathological fear of inflation which they see as the inevitable consequence of excessive government budget deficits.
But Germany’s irrational fears of inflation are storing up the conditions for a far greater crisis down the line. The euro contagion could now very well spread to Italy Portugal Spain and Ireland, all of which (under the terms of this package) have to lend to Greece, at around 5%. So what happens to their funding costs? They go north of 5% as a next step. In the US, when good banks took over bad banks, they became bad banks themselves (see Bank of America and Countrywide). And what about the seniority structure of these loans? Do they subordinate Greek Government Bond holders? One assumes yes, but this is not made clear by the rescue package. In short, this appears to be a cobbled together solution, and it won’t work for a Spain or an Italy. There’s no clarity even on how it gets ratified. The EU says it’s done, but Germany and Holland say they need Parliamentary approval (which can easily be delayed).
Let’s be clear: in the aftermath of World War I, German production capacity was either significantly damaged, or redirected toward output required by the military. The Allied blockade further restricted imports well into 1919, and in 1923, French and Belgian troops occupied the Ruhr valley which held a good deal of Germany’s manufacturing base. All of these measures significantly restricted Germany’s capacity to produce, fueling the distributional conflict that fed the hyperinflation.
There is nothing like that today in Germany, yet “Weimar 2.0″ thinking predominates in much the same way that “Maginot Line” thinking dominated French thinking in its defense establishment. The obsession with a”defense” against the “external” threat of inflation, is blinding Germany. It doesn’t see the risk that the collapse of aggregate demand within the European Monetary Union will ultimately lead to a collapse in Germany’s export sector (a large chunk of which is the product of intra-European trade), and the corresponding extension of the “PIIGS” disease of slow growth and high unemployment to the heartland of the euro zone. We know how it ended for France, once the Maginot Line proved to be a defense more apparent than real.
We hope that Germany’s similarly “successful” defense of inflation does not lead to a comparably disastrous result for Europe today.
Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.
Hi Marshall,
Any source on the back-door monetization ? There is an article by Buiter on this where he says similar things. However, it is not needed. Banks can buy government bonds and make deposits for them - there is no monetization involved. Governments have held around €200b+ as bank deposits for example.
Banks participating in the Main Refinancing Operations using government debt as collateral is just a part of monetary operations. The ECB through the NCBs help bank satisfy reserve requirements by lending them reserves. The lending rate is decided by the ECB and the “tender” (fixed rate vs. variable rate) as well. Of course even in the US, the Fed provides overdrafts, but unlike the Euro Zone, banks are not indebted to the central bank.
The institutional setup of the EZ is an “overdraft financial system” as opposed to asset-based financial systems such as the Anglo-Saxon economies. Banks have always been indebted to the central bank and the claims are high unlike the case of the US or other Anglo-Saxon economies even during pre-Euro times.
The yield movements are simply due to current account deficits and the fact that there is no mechanism for a relief on yields.
Posted by Ramanan | April 12th, 2010 at 1:39 pm
An excellent article, as usual.
You know, an interesting fact is that the German word for “budget crisis” or “debt crisis” is “Haushaltskrise” - literally, a household crisis. The word for Governmental budget is likewise “Staatshaushalt.” That’s right, the Goverment-Household analogy is embedded in the very German language. It’s enough to lead one to give the Sapir-Whorf hypothesis another close look!
Posted by Mattay | April 12th, 2010 at 1:44 pm
Ramanan,
Does it look like to you that the current account deficits drain reserves from the importing nation’s system (balances leave Greece and flow to Germany to pay for the products, leaving the Greek NCB system reserve deficient), then to maintain interest rate policy, the import nations NCB (Bank of Greece) has to add reserves via a repo with dealer banks in the exact amount of the current account deficit?
Resp,
Posted by Matt Franko | April 12th, 2010 at 8:46 pm
Ramanan,
I spoke to a few people at the INET conference who seemed to confirm that I was right on my characterization, but I have also seen an interesting email exchange you had with Marc Lavoie, and if you have any more thoughts on this, I’d love to hear them.
Posted by Marshall Auerback | April 12th, 2010 at 10:30 pm
Matt,
I initially thought that a reserve drain due to current account transactions (and more generally balance of payments) may cause NCBs to purchase government debt. Since the loss is permanent, there will be an outright purchase of government debt.
However, I recently learned from Marc Lavoie that the mechanism is different. In the US, the Fed may do a repo/outright purchase, but in the Euro Zone, the banks just become more indebted to the central bank. The surplus countries will reduce their indebtedness to their NCBs.
The difference is that in the case of the US, the “compensation” occurs by credit to the domestic banks rather than to the local government. The fact that government debt is a collateral is a slightly different matter.
However, Marshall’s point about back-door-monetization is interesting and I would love to read/analyze more about it. My point was that banks lending the government is out of personal choice and if the Eurosystem stops providing reserves, they have another route to purchase government debt which is via creation of deposits. I had earlier thought that the latter is not allowed, but it doesn’t seem so.
Posted by Ramanan | April 13th, 2010 at 2:09 am
Hi Marshall,
Thanks for your reply. Will certainly try to analyze this - it seems more of a bullying to me from the Germans than imposing an explicit financial constraint by the ECB.
Posted by Ramanan | April 13th, 2010 at 2:28 am
Living in Germany I can only say: This article is spot on! Just yesterday I read in Handelsblatt, the leading the financial daily, the following editorial (my translation):
“The president of the ECB, the french man Jean-Claude Trichet, is not anymore the heir of Frankfurts monetary authorities, who comitted themselves to the one great goal: Never ever inflation again. Not once again should savers and small income earners be deprived of the fruits of their labor. Such was the thinking of generations of Bundesbank presidents. It’s also part of the founding documents of the ECB. But the Greek crisis shows that the ECB follows policy objectives rather than the culture of its ancestors. Trichet wants to save Greece, he wants to boost the economy and particularly he wants to avoid the dispute with politicians. What was true yesterday is no longer true: high-risk Greek government bonds will be accepted after all as collateral. IMF assistance is welcomed. Only recently this approach was condemned. The risk of inflation is downplayed by Trichet and considered ‘moderate’. For his ancestors the sentence of Bundesbank president Otmar Emminger was still valid: ‘Who flirts with inflation, will be married to her’. Trichet kissed her yesterday. For the spirit of the Bundesbank this kiss was fatal.”
That’s really pathological …
Posted by Stephan | April 13th, 2010 at 2:47 am
Hi Ramanan thanks,
I was mistaken here too, trying to apply US-like procedures, apparently its not the same in EZ, follow you here.
What is the form of this “indebtedness”? Are the banks reserve deficient and this is the “debt”? ie they “owe” reserves? but in EZ the NCBs let the banks in their jurisdiction be reserve deficient if need be? Does this debt to the NCB appear on the Bank of Greece balance sheet here as an asset?
OK, so here in the US a system reserve deficiency can be met with US Treasury Purchases by the Fed or Repos of Treasuries between the Fed and member banks, these result in an increase in bank system reserves I think I follow you here. Now you say “rather than to the local government” and I’m losing you here. How does the Greek Treasury account get credited at this point? By the banks just purchasing Greek bonds without having to have any reserve balances to be able to do so?
“via creation of deposits”: ‘loans create deposits’ but where is this loan? Is this loan the “debt” you refer to in your para. 2?
Ramanan, I would appreciate your unique insights here…
Resp,
Posted by Matt Franko | April 13th, 2010 at 4:47 am
Hi Matt,
Always great to discuss with you. This article at Roubini has interesting points http://www.roubini.com/analysis/97234.php
Yes the indebtedness will be the item “Claims on banks”. In the balance sheet you linked, it is high - €41b or so, though one may say that this is because of the €442b LTRO by the ECB during May/Jun 2009.
Many times, it is difficult to just look at balance sheets and figure out if an economy is overdraft or “asset-based”. We know that in the US, the Fed provides overdrafts, discount window loans etc. but usually banks get rid of these liabilities.
The Fed does open market operations by calling up a primary dealer. However, in the EZ, there is no “open market operations” as such, even though they call it an open market operation. The NCBs issue “tenders” and do weekly refinance operations where it lends for collateral. The lending is mainly to help banks satisfy reserve requirements. Of course banks cannot borrow too much from the NCB and hence there are both kinds of interbank markets - both secured and unsecured.
So the weekly operations are really “discount window” operations, but the rate is exactly the policy rate, but there are complicated rules and the allotment is not unlimited.
When I meant “credit to local government” I just meant that instead of the Bank of Greece purchasing govt debt, the adjustment (for reserve requirements ) happens via “Claims on banks” increasing instead of Government debt increasing in the balance sheet.
About the point on loans, I was merely pointing out the fact that banks can directly purchase government debt, without using their reserves at their NCBs but via increasing their deposit liabilities. The government’s deposit account at the bank increases and in exchange the government issues bonds to the bank - so loan in that sense.
Posted by Ramanan | April 13th, 2010 at 5:46 am
Oops too many grammatical errors @546 !
Posted by Ramanan | April 13th, 2010 at 5:50 am
Ramanan youre response was helpful as usual.
“instead of the Bank of Greece purchasing govt debt, the adjustment (for reserve requirements ) happens via “Claims on banks” increasing instead of Government debt increasing in the balance sheet.”
To Marshalls point on the Germans accusing the Greeks of “backdoor” monetisation, if the Bank of Greece just bought the bonds and placed the bonds on the balance sheet, this they would call “front door” monetisation. So when Greece uses the method you describe, the Germans call it “back door”.
The Greeks IMO do not know how to defend themselves. When they are accused of monetisation they should just say something like: “no, we are not monetising, we are merely entering the 2nd half of a standard dual entry accounting transaction that is offsetting the first half of the transaction which was a reduction of Greek system reserves caused by your exports to Greece.”
You guys should put a consulting group together and get to the Greeks on this. They dont know how to defend themselves. Perhaps work thru Stiglitz as I believe he has a consulting vehicle in place to Greece.
Resp,
Posted by Matt Franko | April 13th, 2010 at 7:32 am
Here’s another perspective from a German reader - it is certainly true that the “inflation? never again!” -attitude has become almost genetically ingrained into fiscal and monetary policy in Germany. That is, however, not only the consequence of the period of hyperinflation after World War I: only a generation later stealth inflation during World War II and another currency reform afterwards wiped out savings once again.
In the current crisis, the consequences of pushing ahead with extreme austerity measures for most European countries may indeed be disastrous, not the least for export-dependent Germany: deflation, negative GDP “growth”, high jobless rates, another banking crisis etc. While I certainly understand the arguments being made in favor of what some call “solidarity” and others call “bailout” of the weaker members of the Euro-zone (Martin Wolf has published a number of excellent articles on the issue in the FT), the often touted recipe for salvation, i.e.much looser fiscal policy in the surplus countries and a potentially softer monetary stance by the ECB (=acceptance of higher levels of inflation in the medium term) does not come for free either. An expansionary fiscal stance in Germany, coupled with less austere policies elsewhere, may not necessarily be a long term cure for the underlying imbalances, but in the short term will certainly lead to a rapid deterioration of the German indebtedness, while the weaker European states may postpone their own budgetary measures even further. The result would be much more pressing debt issues all around.
Inflation rates of 4 or 5% as suggested by the IMF would simply make the savers, i.e. the population at large, lose out over time, while it is unclear whether the overall indebtedness could be addressed that way.
Conclusion: there is no easy way out. It is one thing to criticize Germany’s stance, and there are good reasons for doing so. The alternatives don’t look any more palatable though.
Posted by Andreas | April 13th, 2010 at 8:09 am
Matt,
Regarding banks’ behaviour I think - and this is very speculative - Greece banks buying government debt seems to arise out of liquidity pressures. Because of the rating agency downgrades, market expectations, the haircuts would have increased in the recent past I am sure.
Banks rely on government bonds as well for clearing payments. Typically, the gross amount of payments that happen in a few days is typically the whole year’s GDP. (For example, in the US, its around a trillion or more daily right?) This puts a pressure on banks and they may need to purchase more government debt because government debt is used in the repo markets so that payments are netted. The haircut increase causes banks to purchase more government bonds/bills. So I do not think that the Greek banks are buying it for some kind of strategy where they want to earn some spread differential. They definitely will know that it is a risky trade especially in this environment. If this is true, it is unfair to prevent them from purchasing government debt.
Posted by Ramanan | April 13th, 2010 at 8:22 am