If the comments from overly excited EU parliament members leaving a “closed door” meeting with Mario Draghi are correct then the ECB president is about to announce a plan to buy unlimited short-term sovereign debt up to 3 years on the proviso that national governments formally request assistance and are therefore bound to fiscal compliance via an MoU.
I am yet to hear any negative reaction for the plan from anyone of importance within the European elite and it is a fair assumption that the major players have been pre-informed of the basics of the proposal. The question is just how much has been shared and whether this is actually a “plan”, or simply a vague proposal for one.
I find it difficult to believe that the “open ended” nature of the plan is acceptable to the many Northern European governments and it is also difficult to see how this isn’t direct funding of governments. We’ve also already heard from the German Finance Minister, Wolfgang Schauble, warning people to lower their expectations. That said, if Mr Draghi has managed to negotiate the political minefield of Europe to allow for unlimited purchases of sovereign bonds then it is a huge break-through. I do, however, remain sceptical that this is the case given the proximity to the German constitution court decision and the multitude of times previously these sorts of rumours have been shot-down.
We’ll have to wait until Friday morning (Australian time) to get the story from the horse’s mouth but already the Spanish and Italian yield curves have fallen sharply led by the front end. This obviously isn’t the first time that Mario Draghi has announced emergency measures with the SMP and LTRO programs used over the last year and it certainly isn’t a surprise to me that the ECB is again at the front of the crisis with this action.
As I stated back in January in response to a S&P rating downgrade:
Although I don’t completely agree with S&P assessment of the ECB I do agree with the following statement:
the ECB may yet engage in additional supporting steps should the sovereign and bank funding crises intensify further
There is no doubt in my mind that this will be the case for no other reason than the “fiscal compact” is just the same policies we have seen over the last 24 months. If periphery nations are forced to deflate their economies in line with their productive capacity under the current European policy settings then the ECB will have no choice if it hopes to meet its mandate of price stability. The fact is that only after the existing debts are written off can Europe enter a phase of economic recovery.
The question that I think we will see answered in 2012 is exactly how this will occur. Will it be by default, starting with Greece, by transfer via yet another newly cobbled together shared issuance mechanism, or via the continuation of the expansion of the central bank’s balance sheet? S&P appears to be siding with the later which, given recent history, I think is a fair bet.
And this leads back to what I have said previously about the enactment of supra-European austerity in Europe and the expected outcomes for struggling nations under these circumstances:
A country with a long running current account deficit has been borrowing goods and services from the rest of the world. In order to support this the non-external sectors of the economy will have expanding debt positions and due to this an economy structured around consumption over production. Because the external sector is a net drain on capital from the country, the government and/or private sector must continually expand their debt in order to maintain economic growth.
In many cases this debt accumulation leads to asset bubbles, because the expanding debt drives asset prices which attracts speculation and in doing so accelerates the external borrowing. This in turn drives up national income, which in turn drives higher prices and further speculation. If a sector’s debt is accumulating faster than its income then at some point in the future a limit will be reached and the rate of debt accumulation will fall. This leads to falling asset prices and national income, which ultimately leads to a crisis as accumulated debts start to sour.
This is what we have seen across the European periphery, although the debt has accumulated in different sectors of the economy across different countries. Ultimately, however, once a European country falls into crisis the debt has ended up in the government sector, even if it didn’t start there, because Europe has chosen to keep banks alive at all costs. This ideology, however, is the major issue with the “Austerity” plan.
After a financial crisis the private sector tends to have lost significant amounts of wealth which leads to both the loss of demand for, and ability to support new borrowing. The debts to the rest of the world still exist which tends to mean the external sector is still in deficit even with lower demand for imported goods. This means that in order for the nation’s income to remain at the previous level the government sector must go into deficit to offset the fall in private sector credit creation. If this does not occur then the economy will shrink until a new balance is found between the sectors, which basically means the economy will try to find equilibrium at some lower national income, and therefore GDP.
This is the sort of deflationary policy that Europe is endeavouring to implement in the European periphery. There is just one BIG problem. At a lower national income the country has no ability to service the debts that it accumulated on its previous income, yet that is what Europe expects to occur. This is simply delusional, because it is a mathematical impossibility and in trying to break these basic laws of arithmetic Europe is slowly destroying the economies of the European periphery which will, in turn, bring down the stronger economies.
And so, in short, the fiscal response to the debt crisis is shrinking the economy of Europe and by doing so the existing debt burden is unable to be serviced which, without actual debt write-downs, requires on-going expansion of the ECB’s balance sheet to compensate. The issue is that, as we’ve seen most recently with Spain, as the economies weaken the process accelerates due to efforts by governments to “double down” on the failing response:
As we have seen from nations like Greece and Portugal, a country with a long running current account deficit and a private sector with a desire or not choice to save has significant problems trying to reach a government surplus. Once you understand that the external sector and the private sector are a net drain on national income it isn’t hard to see the problem. Under these circumstances there is simply no room left in the economy for savings in the government sector and attempts to reach government surpluses become counter-productive as this simply accelerates the decline.
If a country’s current account deficit is structural .. then these efforts are very dangerous because this can easily develop into a damaging feedback loop. The loss of income through the external sector leads to a loss of income in the private sector, this then drives the stronger desire to save, meaning government revenues fall further. This inevitably leads to calls for higher taxes, which once again drain income from the private sector … and around we go. The result of this dynamic is a rise in unemployment, therefore national production and income, meaning once again the government sectors revenue decline while private sector spending and investment fall further.
And that has been my major issue with the fiscal plan for Europe for over 2 years. The policies being enacted to attempt to re-balance the economies of Europe are extremely destabilising and aren’t a credible plan that will allow struggling economies to get back on their feet in order to meet their on-going obligations. It would appear now that these failings are now flowing out to the rest of the world, as I suggested they would:
So while there is no credible counter-balance for the effects of supra-European austerity any attempt to implement the new “fiscal compact” will make Europe’s economic issues worse. The continent is already on the way to recession and unless we see some additional action from the ECB, or a huge swing against this new framework, the push to implement the outcomes of the summit will simply accelerate that outcome. My assumption is that, if Europe does ratify this framework (there are a few stragglers), after 12-24 months of trying the effect will be so disastrous that they will eventually give up. But until then my base case for Europe is a significantly worse economic outcome.
I could be somewhat more positive if I thought the rest of the world was going to be able to provide the sort of demand for European products and services of a magnitude that could offset internal European deleveraging. However, in the current global environment it isn’t going to occur and the inter-dependencies between Europe and the rest of the world guarantee that a slowing Europe means a slowing globe.
Action by the ECB this week is, in whatever form it takes, is yet another compensatory action for the broader policy failure. I do however expect such action in its final form to be watered down under political constraint which means, if it is the case, I’ll be back discussing whatever then next intervention happens to be in another couple of months.