What Mr Draghi should be aiming at: Or how to move from Ponzi Austerity to Rational Crisis Management by a stepwise implementation of the Modest Proposal

17/08/2012 by

Ponzi growth happens when unsustainable capital flows, wilfully predicated upon funding schemes that Reason knows to be fraudulent, give rise to large spurts of economic activity.

Ponzi austerity, in contrast, is what happens when unsustainable spending cuts, wilfully predicated upon funding schemes that Reason knows to be fraudulent, cause significant drops in economic activity. (Click here for my original piece on Ponzi Growth and how it led to Ponzi Austerity.)

It is an incontestable fact that Europe’s Periphery shifted from Ponzi growth to Ponzi austerity some time after the Crash of 2008. Before the Crash, tsunamis of toxic money, minted and multiplied by US, UK and German banks, flooded the Periphery, causing bubbles in the real estate and public sectors. When that toxic money fizzled out, and capital receded from the Periphery like a vicious tide going out on a grim shore, the Periphery’s states and banks sunk deeply in the mud of irreversible insolvency. So as to delay the inevitable defaults that would strike huge blows on the tittering northern banks, so-called bailouts were arranged on condition of austerity policies that were as unsustainable as the growth whose collapse led to them.

The European Central Bank (ECB) is the only serious institution that the Eurozone has. It was meant to be the guardian of the euro’s credibility but, alas, during both periods (Ponzi growth and Ponzi austerity), the ECB proved incapable of playing this role. When toxic capital flowed disastrously into the Periphery, the ECB whistled in the wind. When it flowed out, causing the collapse that then gave rise to the Ponzi austerity, the ECB was part and parcel of this crime against the peoples and the spirit of Europe. Now that the chickens are coming home to roost, the ECB is pledging to do “all it takes” to save the euro, but fails to back up such strong words with deeds.

The reason for the ECB’s failure is that its most powerful constituent part, the Bundesbank, is refusing to contemplate the two ‘normal’ operations that would stabilise the euro: (a) capping Peripheral spreads via unlimited bond purchases, and (b) a banking license for the EFSF-ESM in conjunction with a commitment to recapitalising banks directly. German opposition to (a) is predicated upon moral hazard arguments (i.e. the fear that, if Italy’s spreads are capped at a sustainable interest rate level, the Italian governments of the future will have no incentive to ‘pull itself together’). As for Germany’s opposition to (b), it is due to private German banks’ point-blank refusal to submit themselves to ECB (or non-German government) scrutiny; a development that is inevitable if an ECB-leveraged EFSF-ESM steps in to re-capitalise the banks.

The ECB’s short-term part in perpetuating Ponzi Austerity

In the short-term, Mr Draghi’s ECB is an active participant in Ponzi austerity. Here is a typical example. In July the ECB deemed that Greek banks are insolvent and that the ECB will, therefore, not accept collateral from them. It directed them to the ELA program which has the Central Bank of Greece provide liquidity to the Greek banks (at a higher interest rate than the ECB would) in the context of the ECB system’s ELA. To facilitate this, the ECB permits the Central Bank of Greece to… treble the amount of euros that its lends the Greek banks and to accept worthless collateral from them in return; collateral that the ECB itself would not touch with a bargepole. In effect, the ECB pretends that it is cutting off the Greek banks when, in reality, it is simply increasing these insolvent banks’ costs of borrowing without limiting the quantity of money that they borrow from the ECB’s broader system. In effect, it is causing, wilfully, the Greek banks to plunge deeper into insolvency.

Why is Mr Draghi allowing this to happen? Because the ECB wants its money back from the Greek state on 20th August! Some of you may recall that, in the heady days of the summer of 2010, the ECB stepped into the secondary bond market to purchase Greek, Portuguese and Irish bonds in a failed bid to shore them up. Now, some of these bonds are maturing. While the tranches held by individuals and banks were haircut ruthlessly (54% in face value and 75% in present value terms) last March, the ECB insisted that its Greek bonds will not be touched by the haircut (or PSI as it was called euphemistically). To maintain this façade of super-seniority, with a view to imposing it on Italy and Spain later (now that Mr Draghi has promised to step in and buy Italian and Spanish bonds), the ECB presently demands from the Greek government full repayment. Last May, the Greek state borrowed 4.2 billion from the EFSF and passed every cent to the ECB. The same was meant to happen on 20th August. However, Berlin insisted that the bailout tranches for the months of July and August be withheld from Greece until the Greek government dances to the prescribed tune. But if the Greek government was to be denied the new EFSF instalments, how could it pay the 3.2 billion due to the ECB on 20th August?

Here is where the ECB chose to become a central player in the saddest and meanest form of Ponzi austerity: While Berlin is pushing Athens to implement a huge cut in the government’s budget (given the shrinking rate of the social economy) of 11.5 billion euros, at the same time, the ECB makes three related moves: First, it declines the Greek government’s request for a one month delay in the repayment of the 3.2 billion it owes the ECB. Secondly, as mentioned above, it cuts Greek banks off ECB liquidity and turns them toward the Greek Central Bank’s ELA program; thus increasing their borrowing costs. Third, it permits the Greek Central Bank to provide to the Greek banks liquidity that the latter then pass to the Greek state so that the Greek state can, in theory, repay the ECB the 3.2 billion due. Indeed, on 14th August, while most Europeans, and Greeks, were on holiday, the insolvent Greek government issued around 4 billion euros of T-bills for the purpose of pretending to pay off a debt of 3.2 billion to the ECB. Why pretending? Because these T-bills were snapped up by the insolvent Greek banks for the purpose of posting them as collateral with the European System of Central Banks (via Central Bank of Greece and in the context of the ELA) so as to gain access to much needed liquidity. In a full and ridiculous circle, the ECB system financed the Greek state’s repayment to the… ECB guaranteeing, in the process, that the insolvent Greek state’s debt and the insolvent Greek banks’ debt grew.

While this is an extreme example of the ECB’s complicity in a macro-financial debacle (if not scandal), it is not unique. At the very same time, the Central Banks of Italy and Spain are forced to make use of precisely the same provisions to their insolvent banks so that they can purchase expensive short-term T-bills in order to finance their governments, to the tune of tens of billions of euros. It is a ‘trick’ that was first tried and tested in Ireland, as part of the operations that caused the Emerald Isle to slip into Greece’s wake, on the way to Bailoutistan.

To recap, in the short-run, Mr Draghi’s ECB is participating, knowingly, in a huge game of deception that, to all intents and purposes, constitutes a vicious system that can only be described adequately as Ponzi austerity. Mr Draghi surely knows this and is keen to break out of this deadlock. He has, in fact, promised to do precisely this in the medium term. But what exactly are the options that he is considering?

The ECB’s medium term plans

Mr Draghi has signalled a readiness to sidestep the Bundesbank’s objections, with the tacit support of the German chancellor, and re-start the program of ECB-purchases of Italian and Spanish debt (bonds, that is) in the secondary market as long as (i) the EFSF-ESM does likewise and (ii) Rome and Madrid agree, explicitly or implicitly, with a deepening of austerity policies and a broadening of so-called reforms (for which one should read: attacks on any regulation that shores up labour’s bargaining power over capital). The trouble with this plan is that it is bound to fail. The reasons are not hard to imagine:

The fact is that the ECB Board, even if it overrules the Bundesbank’s objections to this plan, will never authorise Mr Draghi to announce unlimited bond purchases. Consider the bond purchases of the past (i.e. the purchases of Italian, Portuguese and Irish bonds in the summer of 2010 and winter of 2011). They failed miserably because it was common knowledge that the ECB had only a couple of hundred billion euros to play with. This gave a splendid opportunity to speculators to bet that this (commonly known) sum would not be enough to shore up these bonds and lower their spreads in the medium term. They placed their bets against the ECB and won. Similarly now, given that the EFSF-ESM’s available sums are a pittance (and, to boot, it is still unclear whether they can be released in a flexible manner for this kind of use in the secondary markets) if the firepower available to Mr Draghi (stemming from the ECB’s printing presses), to fight the war on behalf of Italy and Spain, is also circumscribed, the markets will bet against him and will win hands down. This is the reason why everyone keeps proposing that either the ECB should declare (like the Central Bank of Switzerland in its fight to cap the franc) that it will print and allocate unlimited euros to cap Italian and Spanish spreads or, equivalently, that the EFSF-ESM should be given a banking licence; i.e. the right to use the ECB’s printing presses and asset book as a lever that accomplishes the same purpose.

To sum up, what would buy the Eurozone a good five years during which to redesign the Eurozone and avert the euro’s long term disintegration is either an unlimited power to print (so as to cap spreads) or a banking licence for the EFSF-ESM, coupled with a proper delinking of bank recapitalisations from the national governments (i.e. taking the capital injected into the banks off the national accounts of governments). Trouble is that Berlin is not willing to countenance either of these measures. Thus, the hapless Mr Draghi is forced to choose between a walk-on part in the unfolding tragi-comedy of Ponzi austerity and a bond purchasing scheme whose failure is foretold.

Is there an alternative? How Mr Draghi could adopt part of our Modest Proposal to break the vicious circle vis-à-vis Italy and Spain tomorrow morning

Imagine a press conference tomorrow morning in which Mr Draghi makes the following announcement:

“Henceforth the ECB will undertake a Debt Conversion Program for Italy and Spain. It will service (as opposed to purchase) a portion of every maturing Italo-Spanish government bond corresponding to the percentage of each country’s public debt that is allowed by the Maastricht Treaty.”

[In effect, it will be servicing 100[(D-E)/D% of each maturing bond, where D is the national government’s debt-to-GDP ratio (in %) and E is the difference between D and 60% (the Maastricht-compliant level). Assuming Italian and Spanish debt-toGDP ratios to equal 120% and 90% respectively, then the ECB would be servicing 50% of each Italian government maturing bond and 66.7% of each Spanish government maturing bond.]

“To fund these redemptions on behalf of Italy and Spain”, Mr Draghi will go on to say,” the ECB will issue bonds in its own name, guaranteed solely by the ECB but repaid, in full, by the respective member-state: Upon the issue of ECB bonds, the ECB will simultaneously open debit accounts for Italy and Spain into which the two countries will be legally bound to make deposits to cover the ECB-bonds’ coupons and principal. These new debts of Italy and Spain to the ECB shall enjoy super-seniority status and shall be insured by the EFSF-ESM against the risk of a hard default. Since the cost to the EFSF-ESM of offering this insurance will be minuscule (compared to the cost of purchasing, in association with the ECB, hundreds of billions of Italo-Spanish bonds), the EFSF-ESM will now have significant funds to devote to the task of directly recapitalising Italian and Spanish banks.”

Is there any doubt that such an announcement would spell the current crisis’ end? Moreover, do note dear reader that there is nothing in this Debt Conversion Program that violates the principle of no monetisation of the Periphery’s debt, no issues of moral hazard (since Italy and Spain will still have to service, on their own, the past of their debt that exceeded Maastricht limits) and no increase whatsoever in German, Dutch, Finnish or Austrian liabilities. Italy and Spain will enjoy large interest rate reductions without any concomitant rise in the long term interest rates that Germany pays (since Germany is not guaranteeing the Program), without any bond purchases by the ECB (funded by money printing), without a banking licence for the EFSF-ESM. And if this Program succeeds, it can be quickly extended to the rest of the Eurozone, thus creating a new, liquid market for proper Eurobonds (ECB-bonds) that will both stabilise the Eurozone and draw idle savings into it from the rest of the world.

Concluding remark

I submit it to you, dear reader, that this plan would work. So, why is Mr Draghi not announcing it, insisting instead on measures that will ultimately fail? Because of a combination of reasons. Some of them have to do with the inability of our central bankers (and politicians) to embrace original thinking (i.e. thinking that does not just replicate the practices of Goldman Sachs and the various outfits in which they cut their teeth before moving to their current jobs). However the most telling reason is that Berlin, and the other capitals of the surplus nations (Finland, Austria and the Netherlands), will not approve of any move or policy that binds them irreversibly to the euro. The Debt Conversion Program suggested here, while it requires no loan guarantees from German and Dutch taxpayers, creates a new type of bond that makes it impossible for the surplus nations to leave the Eurozone. It is not that they want to leave that causes them to veto ideas like this one. It is that they do not want to give up the relative bargaining power (vis-à-vis France and other member-states) that is afforded to them courtesy of the capacity to leave the euro. Alas, the preservation of that capacity may force all of us to bid adieu to the common currency; with tragic consequences for all.

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