Friday 23/9/2016 (click here for the Eurofinance site & here for a related Keynote speech)
How long can Europe go on like this? In mid-July Germany sold €4.038bn of 10-year zero-coupon bonds with a yield of minus 0.05 per cent. This added a few more billions to the more than €4.25 trillion euros-worth of euro-zone government bonds that now carry a negative yield. These yields and the ECB’s €80-billion a month quantitative easing policy have now infected non-government markets. According to Bank of America, the highest-rated euro-denominated senior and secured debt of non-bank companies maturing in one to three years yield an average minus 0.08 percent. And there’s no obvious way out: at the ECB’s July meeting the bank kept the main refinancing rate and the deposit rate at record lows of zero and minus 0.4 per cent.
These distortions represent the limits of monetary policy, itself compromised badly by the weakness of the banking system. Europe’s banks are sitting on €1 trillion of bad debts. In Italy 17% of all assets are non-performing. Banks continue to be urged to bolster capital ratios while at the same time their profits are cut by slow growth, regulation and new Fintech competition. In their current state, banks are unlikely to use the money generated by QE to boost lending to the real economy. All it is in fact doing is boosting asset prices and inequality.
More profoundly, negative or zero rates destroy both savings and the notion that saving is a good idea. Couple that change with permanently lower wages and wage growth and the implications are extreme. The minority who can borrow, buy and rent out to the rest. The ownership economy is replaced with the rental economy – not just in housing but in everything from music to hailing self-drive cars off the street. People who don’t own don’t need insurance. People with no savings don’t need financial products of any kind because they can’t afford them. So what happens to pensions and other savings products and to the institutions that provide them? A significant diminution of the size of institutional investors has knock-on effects for capital markets and both public and private sector borrowers. These are seismic changes that look back to a world last seen by our grandparents.
Brexit has just made things worse. By increasing uncertainty and impacting trade, according to the ECB’s latest minutes, the UK’s decision to break ties with the EU “could affect the global economy in deeper and less predictable ways than through the direct trade channel. In the current environment of heightened uncertainty, a still high level of economic slack and weak wage and price pressures, future discussions were called for regarding wage trends, inflation expectations, the medium-term orientation of monetary policy and the time horizon over which the very accommodative monetary policy stance would remain warranted.”
Extended uncertainty and low growth will prolong the banking crisis. And recent research published by S&P, a rating agency, suggested the UK leaving the EU could limit the effectiveness of the ECB’s negative interest rate policy, by lowering the value of the pound against the euro.
So will the solutions to these problems come from the embers of old political discourse or from the ideas of the new?
Yanis Varoufakis was the Greek Minister of Finance from January to July 2015 and Syriza Member of the Hellenic Parliament (MP) from January to September 2015. Interviewed in August, by Treasury Perspectives, EuroFinance’s annual publication, he is clear that Europe cannot go on as normal.
“The Eurozone and EU are reacting in a knee jerk manner [to Brexit] and that in itself will speed up the process of the disintegration of Europe. For example, we are seeing the banking system in Italy go from bad to worse. We are seeing a backlash by citizens who don’t want to see more sovereignty housed within a central EU. There are further deflationary forces within the continent and these are the problems. That was always my concern and it still is,” says Varoufakis.
Fixing the Euro
His view, and he’s not alone, is that at the core of the Eurozone’s problems is the euro itself. That means that any meaningful fix requires a number of different, and very significant, initiatives. “The first thing we need is a proper investment-led New Deal for Europe,” he says. The distortions caused by the euro currency union have led to the ECB’s Quantitative Easing programme (QE). However this in turn has led to excessive purchases of German government debt, causing negative yields there, while not causing interest rates to fall far enough where they are needed – in the real lending markets of struggling economies.
Instead, QE is simply inflating asset bubbles and social inequality. Indeed, as this Bank of England video explains [https://www.youtube.com/watch?v=CvRAqR2pAgw], QE could never have benefited the SMEs who really needed it because it operates solely through the capital markets, because the commercial bank reserves created do not imply increased bank lending and because the QE mechanism can work to lower bank lending if companies who do use the capital markets use lower yields created there to repay high-yielding bank debt.
One solution, he suggests, is that QE purchases be directed solely at bonds issued by the European Investment Bank. If the EIB issued significant amounts to be purchased by the ECB, the effect would be to print money directly into real infrastructure projects and on-the-ground spending while maintaining the current low yield on EIB bonds.
“The European Investment Bank (and its smaller offshoot, the European Investment Fund) should embark on a pan-Eurozone investment-led recovery programme, focusing on green technologies and green energy, worth between 6% and 8% of Eurozone GDP. The EIB would concentrate on large-scale infrastructural projects and the EIF on start-ups, SMEs, technologically innovative firms, etc. This form of QE backs productive investments directly, and help shift idle savings (which currently depress yields on all investments) into productive activities. This would be tantamount to a European New Deal.”
A step-by-step (proper) banking union
As with the euro, there is general agreement on the problem – and on the end game required to solve it. But because that end game of a full banking union implies a fiscal union (all Eurozone taxpayers stand behind all 6,000+ eurozone banks), no one can agree on the transition.
Varoufakis believe that there is a way forward without creating full banking union in one go. “We need a step by step banking union with an insurance scheme,” he explains. “Every time a Eurozone bank needs to be recapitalised with public funds, the government of the Member State in question will have the option of allowing the particular bank to drop out of its national jurisdiction. That bank then is admitted to a new (special) Eurozone jurisdiction. Once there, the ECB appoints a new board of directors (who have never served on any board of the bank’s previous national jurisdiction) with a remit to cleanse the bank and to work together with the ESM-ECB to resolve or recapitalise the bank.”
The idea is to break the “death embrace between insolvent banks and fiscally stressed states” while letting “the European taxpayer [see] exactly where his or her money has gone.” This would also mean that the often corrupt relationship between national politicians and ‘national’ bankers becomes a thing of the past while building a new Eurozone-wide banking jurisdiction step by step.
Solving the real problems
The financial sector is the Gordian knot at the heart of Europe, but, day-to-day, Europe’s material reality is one of high youth unemployment, increasingly precarious jobs, declining real wages, and poverty pensions. Austerity and the refugee crisis has crushed the Greek economy and created conditions – hospitals running out of medicines, for example – more normally associated with struggling emerging markets. The same forces are fracturing the political and social consensus across Europe, most obviously in the UK.
Immigration and economics drove Brexit. Even in supposedly successful Britain, almost all the jobs created since the financial crisis are “non-standard” – self-employment of one form or another. Not entrepreneurship but people forced the new precariat of the zero-hours contract (or what we used to simply call “temping”. These new workers, without a predictable income and with few employment rights are hardly the foundation for economic and financial system recovery.
Varoufakis has seen all this up close. First in his native Greece and then campaigning against Brexit in the UK. He began convinced Brexit would not happen, but realised, when he moved away from the large cities, the impetus towards leaving was strong. “I was struck by what I was hearing from the working class in England and that made me think [that Leave could win],” he says.
Without policies to solve the 21st century problems of post-industrialisation, demographics, digitalisation and new technology, Europe’s crisis will become increasingly a crisis of democracy and social structure. The current situation is untenable: austerity imposed by the North is increasingly creating two, incompatible Europes and re-igniting a populism conventional politics will struggle to contain.
For Varoufakis the moral obligation to alleviate hardship actually presents an opportunity to re-kindle the feeling of shared European identity that racist austerity rhetoric – and Northern-imposed austerity itself – threatens to destroy. “We need an anti-poverty programme that binds Europe together,” he explains, “A joint fund for dealing with impact of social impact of the Eurozone crisis, something like the US food stamps programme to put food on the table. This is a chance to build a major bonding exercise that creates a positive atmosphere in which people feel European again.”
Funding is always the issue and here Varoufakis believe that the profits countries like Germany have made lending to those like Greece are the answer. Target2 liabilities have accrued billions in interest payments from the central banks of the deficit to the central banks of the surplus Member States, eventually distributed to the treasuries of the surplus Member States by their central banks.
“The proposal here is simple: Use these funds to pay for an American-style food stamp programme that puts an end to hunger. Imagine if the ECB were to fund, using these accrued billions, a Eurozone-wide food stamp programme. Imagine if a family in eastern Germany, another one in Greece, a third in Ireland were to receive a cheque in the post (to be used in the local supermarket) with which to feed its children, signed by Mario Draghi on behalf of the Eurozone! Imagine the impact this would have on creating genuine consolidation and solidarity throughout the monetary union!”
What about the debt?
Underlying all the other problems is Europe’s public sector debt. The debt-to-GDP ratio of the eurozone countries at the end of 2015 was more than 90%. The permitted Maastricht level is 60%. While debt forgiveness has been a central plank of most other debt crises, it remains politically unacceptable in Europe. As with QE, the key question is how to get the money to the right places in the economy?
Varoufakis proposes a way of splitting countries’ debts into two parts – the 60% of GDP chunk (the good debt) and the excess (the bad debt). The ECB undertakes to service the good debt and, on maturity, to repay its principal by issuing its own bonds or backing a new issue by the relevant government. The key point is that the government commits to repaying those new ECB bonds which have been issued on much better terms than the country itself could achieve. Varoufakis calculates that “if we do this for the ‘good’ debt, for the MCD only, of every Eurozone Member State that wants to participate in this debt conversion scheme, a total reduction of more than 35% of the Eurozone’s total debt servicing costs (for the next 20 years) will result. Effectively, the European debt crisis goes away.”
There are a key additional details that preserve ECB creditworthiness and ensure that governments do repay their new commitments, but as Varoufakis says, “This limited debt conversion scheme actually strengthens the Maastricht rules since it gives rise to a substantial interest-rate spread between a Member State’s Maastricht-Compliant Debt (the 60% of GDP) and the rest of the debt that the Member State was not allowed to have under Maastricht. This feature of the scheme answers concerns regarding moral hazard.”
New solutions needed
Whether or not Varoufakis’ solutions are the answer, it’s clear that Europe needs a new discourse. It needs innovation to clear up its ‘conventional’ financial mess. Because without a solution to that, it cannot even begin to solve the much deeper 21st century problems caused by demographics and digitalisation.