As the prospect of Brussels hosting yet another euro-summit showcase of intransigence and impotence looms before us, even the redoubtable Angela Merkel may be forced to contemplate allowing the European Central Bank to become quite a bit more like the US Federal Reserve. Otherwise, European divisions made obvious during the latest Greek elections may become irresistible tidal forces as the crisis reaches Spain and Italy, opening an economic chasm into which even Germany could fall.
In the wake of two rounds of “quantitative easing” that have left the Fed owning about 12% of US Treasury debt, the Fed has announced its intention to continue attempting to stimulate the economy by extending “Operation Twist,” selling shorter dated Treasuries and buying longer maturity T-bonds in order to bring down long-term borrowing costs (see “Uncle Ben’s Reverted Price”). But US long rates are already quite low, indicating that, at least for the moment and despite past and potentially future fiscal fireworks on Capitol Hill, the bond markets remain rather unconcerned about US credit quality. This may be in no small measure due to the Fed’s demonstrated willingness to purchase massive amounts of Treasuries.
By contrast, as euro-crisis contagion spread from Greece to the rest of the periphery, the sharp rise in the yields of Spanish, Italian and of course Greek debt speak to markets’ deteriorating faith in these credits. For a time these rate hikes were held in some check by ECB sovereign debt purchases; since 2010 the central bank has bought some 200 billion euros of Portuguese, Irish, Italian, Greek and Spanish (PIIGS) paper, creating a degree of precedent for this kind of strategy. However, unlike the Fed, the ECB’s constitution does not include a mandate to pursue full employment in addition to maintaining price stability, so the euro’s central bank was forced to act in the name of maintaining the integrity of the banking system, whose collapse could be deflationary. Two German ECB members took such exception to this rationale that they resigned in succession, reflecting Germany’s traditional post-war concern regarding inflation. For Mario Draghi, the ECB president who recently highlighted the limits to what the central bank can do absent fiscal and structural reform in Europe, much more substantial action would likely require German support, and the quid pro quo of at least a somewhat credible promise of that reform.
Like their American counterparts, the yields on German bunds are quite low. And for Germany as for the US, these low yields are not due to low debt to GDP ratios, as the German figure is now near 90% and likely to rise significantly higher with the announced issuance of Deutschland bonds through which the central government will back borrowing by German states. Rather, both the US and Germany are in some sense in command of the mechanism for creating the currency in which they borrow; for the US this power is unambiguously invested in the Fed, while Germany enjoys a kind of negative control of the ECB, since with the exception of Finland and the Netherlands, the rest of the eurozone seems to have little objection to money creation through policies such as sovereign debt purchases.
A crucial point here, and one readers of this blog will be familiar with, is the difference between real default on sovereign debt caused by inflation and nominal default, in which the bonds do not fully pay off, even in a depreciated and inflated currency (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”). Because the latter does not result in an inability of banks and other holders of bonds to meet their obligations (like deposits) payable in the same currency as the bonds, the real default of inflation, though potentially quite pernicious, may not precipitate acute systemic financial crises, and thus institutions may be willing to hold debt at risk of inflation but not nominal default. So at least until the inflationary crows hatched by monetization come home to roost, a central bank’s buying of its currency’s sovereign debt may lower yields on that debt, as may even the possibility of such buying, based on the central banks’ ability to make such purchases.
Germany is understandably wary of letting profligate states borrow on its credit card. If it’s serious about not allowing eurozone-wide “Eurobonds” to refinance peripheral debt, and with the necessarily limited firepower of bailout funds like the European Financial Stability Facility (EFSF) and its successor, the European Stability Facility (ESM) limiting their credibility, an ECB with the theoretically unlimited power of the monetary printing press may have to be the buyer of last resort for the debt of the PIIGS, effectively creating euros to re-liquify the banking system, preventing runs and reflating the eurozone’s economy. For Germany, staying in the euro absent such an action could mean the loss of its periphery export markets while its own bank exposure to those countries drags the German economy down (see “It’s Hard To Make That German Export Wiener Without PIIGS – And That Goes For Chinese Dumplings, Too.”). Alternatively, a report from Merkel’s own government puts the cost of an exit from the common currency at 500 billion euros, with a 10% GDP drop and five million Germans unemployed.
Ah, but there’s the matter of those inflationary blackbirds I mentioned, and an old Spanish saying – if you raise crows they will peck out your eyes. With eurozone inflation running at 2.4% in May and the German rate even lower (1.7% in June), the ECB has some inflationary breathing room, ironically due to a global economy weakened by the euro crisis itself. Yet Germany’s concerns are well founded, and in exchange for a more Fed-like ECB it could and should insist on rapid reforms in Europe. These would have to go beyond austerity and the purely fiscal, embracing structural changes addressing woefully low competitiveness in much of the eurozone. Only then can there be confidence in a limit to monetization and any hope of peripheral countries paying debts current and future. Clear milestones and a commitment to a time scale much faster than the ten years contemplated in European Council President Van Rompuy’s plan would be essential. Unfortunately, the most serious opposition to such reform is likely to come from the new French government, which would have to reverse the newly elected François Hollande’s support of earlier retirement benefits and restrictions on layoffs even as French competitiveness dives.
But hey, what in the last two hundred years of Franco-German relations would cause one to doubt that France and Germany can’t work things out?