Friday, August 07, 2020

Will the Pandemic Bring Down the Eurozone?

 Published on U.S. National Review Online

As the coronavirus crisis subsides in Europe, another crisis may rear its ugly head again: the crisis surrounding the EU’s common currency, the euro. The euro crisis, which came to a head when Greece nearly defaulted in 2009-10, never really went away, and it could have profound consequences for the United States.

No eurozone government has openly declared insolvency during the coronavirus pandemic, but the European Central Bank has undertaken massive financial injections to avoid just that.

On top of this money printing, European governments have been spending like drunken sailors. Germany alone has committed €1.2 trillion in spending and guarantees, more than any other individual EU country. There is a real danger that German support for domestic firms undermines fair competition in the European Union, which its executive, the European Commission, is supposed to guarantee, although in this case it has remained silent.

Recently, European governments agreed to an additional €750 billion in COVID-related stimulus spending, dubbed “Next Generation EU,” which will add yet more to the burden already imposed on hard-pressed European taxpayers. The €750 billion will be borrowed on international markets — perhaps even from China —and jointly guaranteed by European governments, a development of considerable political significance in that it effectively represents a degree of debt mutualization that has thus far been resisted by the EU’s “north.” To pay back the jointly issued loans, the European Commission will be levying taxes directly, an encroachment on powers previously reserved to the members. With a “tax on non-recycled plastic waste” already levied on January 1, a “carbon border adjustment mechanism and a digital levy” may follow.

In Northern Europe, opposition to this spending scheme was firm, as governments realized the extra burden it would put on their national budgets already stretched by the measures taken in response to the pandemic.

The so-called “frugal four” — the fiscally responsible Netherlands, Austria, Sweden, and Denmark — are hesitant to put themselves on the hook for decades of financial mismanagement elsewhere. It should be noted that the latter two opted to stay out of the eurozone and are therefore even more hostile to the idea of underwriting transfers designed in reality to sustain that shaky monetary union. At the European summit, they put up a good fight but basically lost out, having to accept that €390 billion of the €750 billion would consist in grants to European governments as opposed to loans.

An agreement was already reached that the new multiannual EU budget, not including the €750 billion special “coronavirus” stimulus, would once again amount to more than €1 trillion euro over seven years, despite the loss of the UK, which was the EU budget’s second biggest net contributor.

It is not as if the EU spends the money it already has as well as it might.

For a start, it devotes more than €400 billion to agricultural subsidies, irrespective of production, which amount to huge transfers of public resources to industrial conglomerates as well as to landholders, some of whose land just happens to be classifiable as agricultural, including (prior to Brexit) the Queen of England. The system emerged after EU agricultural subsidies had led to massive overproduction, so instead of axing the handouts all together, it was decided to merely decouple them from output. As was noted in a detailed 2019 report in the New York Times, allegedly:

across Hungary and much of Central and Eastern Europe, the bulk goes to a connected and powerful few. The prime minister of the Czech Republic collected tens of millions of dollars in subsidies just last year. Subsidies have underwritten Mafia-style land grabs in Slovakia and Bulgaria.

In the Times’ view, “few leaders have attempted such widespread, brazen exploitation of the subsidy system as [prime minister Victor] Orban in Hungary”. The paper’s reporters argue that he “uses European subsidies as a patronage system that enriches his friends and family, protects his political interests and punishes his rivals.”

“Regional funds” are the EU’s second-largest area of spending. These are supposed to help Europe’s poorer regions catch up, but they have ended up supporting organized crime and the mafia in Southern Italy, according to Italy’s Central Bank. Most economic research has concluded that these funds do not help to close the economic gap, and one study even alleges the funds bring more harm than benefits to regions that are net recipients of this largesse.

Germany, and ultimately the frugal four, are likely to back down in the end when it comes to both regular and post-COVID EU spending. The waste (and worse) associated with EU funds is no secret, but it is often considered as some kind of a “bribe to sustain the EU’s “single market,” which enables businesses to trade across borders more smoothly in Europe.

The single market is a good thing, even if its focus has moved from scrapping national protectionism to harmonizing rules at the European level. Discontent about the latter, along with perennially wasteful EU spending, were two of the reasons behind Brexit. We can already see rising discontent in the more “frugal” countries like the Netherlands or Sweden over the EU’s seemingly never-ending appetite for spending, but that discontent does not foreshadow an exodus from the union, an idea with only minority support in those parts of Europe. In Italy, by contrast, support for leaving the EU and the euro zone was higher in April — at around 50 and 40 percent, respectively — but Italy is financially dependent on euro zone membership. An exit would wreak havoc on its troubled banks.

None of this was properly considered. With the UK’s departure, the voices of those arguing in favor of responsible financial management have been weakened. The COVID crisis helped those pushing for more EU spending to almost double it, while also financing part of it via joint lending, and no longer only, as was the case, bottom-up, via payments to the EU. Also in the future, the EU could decide to cover any shortage of cash via a joint lending program. Importantly, however, the EU Commission’s authority to issue joint debt is time limited. Every EU member state is able to veto any future program similar to the 2010 joint lending program to finance Eurozone emergency loans to Ireland and Portugal, which can serve as the first precedent of joint EU borrowing.

In the end, the 750 billion euro of the new joint borrowing program is still relatively small. Ultimately, it is the European Central Bank (ECB) which is preventing a euro zone break-up.

Taxes are already excruciatingly high in financially weaker countries like France, Belgium, Greece, Italy, Portugal and Spain. The economic damage of Covid is now crushing tax revenue. If those countries’ governments want to avoid big spending cuts, which is a “no go” in Europe, where a social-democratic mindset is mainstream, they need to increase borrowing. That’s where the ECB comes in.

The combined budget deficits of euro zone governments this year amount to an estimated €1.4 trillion, roughly equal to as the extra money the European Central Bank has pledged to inject into the system by the end of this year. By the end of 2021, the ECB’s monetary expansion will, according to conservative estimatesexceed €1.6 trillion , which is a lot more than the €340 billion stimulus the EU Commission intends to dole out until the end of next year.

The ECB has become a crucial source of funding to many euro zone governments. It does this by drastically expanding the supply of money, either buying government bonds on the secondary market or distributing newly printed cash to European banks. This all happens through seemingly endless programs usually identified only in abbreviation: LTRO, TLTRO, PEPP and PSPP. As for the money lent by the ECB to banks, much of it is spent on bonds issued by the euro zone’s governments. In 2011, French President Sarkozy  that the real purpose of the LTRO program was to fund governments: “This means that each state can turn to its banks, which will have liquidity at their disposal.” When it is buying bonds directly, the ECB moreover disproportionately purchases those of the financially shakier member states, meaning it is not just engaged in banana republic–style monetary financing of government spending but also effectively organizing transfers between eurozone member states, and not in a direction appreciated by the eurozone’s north

There are legal constraints in the eurozone aimed at preventing monetary financing, which is rightly seen as undemocratic (it’s a way of increasing government spending that bypasses parliamentary scrutiny), but they don’t amount to much. Recently, Germany’s Constitutional Court ruled that the EU’s “Supreme Court,” the European Court of Justice, had violated the distribution of competences laid down in the EU’s founding treaties by allowing the ECB to conduct its very own “quantitative easing” program, PSPP, without sufficient motivation of the reasons why it’s necessary. The German judges have a history of daring to bark but not to bite, so another fudge was found, with Germany’s central bank simply delivering an explanatory note.

For a long time, German political opposition to the ECB’s monetary activism, stemming from the trauma of 20th century hyperinflation, acted as a brake, but memories are fading.

Complacency over inflation has also been helped by stable consumer prices, despite clear sign of asset-price inflation. One explanation for this is that much of the money created by the ECB and lent to banks has simply stayed put in the banking system. Banks are not lending it out, because they cannot identify enough good projects to fund . Meanwhile, European savers aware that their savings are being slowly eroded remain wary of more active investment strategies, apprehensive that a stock-market or real-estate correction may be around the corner. That interest rates have been driven into negative territory has not changed their mind to any significant degree.

The next stop may therefore be “helicopter money” — sending money to citizens rather than banks. In theory, this ought to drive up the “velocity of money,” as the newly created cash would no longer sit idle in the banking system, but could be used by citizens right away. That’s the theory, but it is possible that many people would still not indulge in a spending spree, and might merely keep the extra money in their savings accounts. Nevertheless, if enough people did start spending right away, consumer prices would go up, “forcing” people to join the spending spree, so as not to lose out. This would all end in runaway inflation.

The euro does not enjoy the reserve-currency status of the U.S. dollar. Its credibility as a store of value is considerably less. The ECB can control how many euros it inserts into the system, but not the degree of trust people have in the single currency. It’s possible to foresee a situation in which the ECB may be forced to increase interest rates to stem capital flight, a phenomenon familiar in those emerging markets where money has been printed a little too enthusiastically.

In the eurozone, higher interest rates would not simply be a matter of political and economic pain. They could threaten the single currency’s survival. Southern European politicians may simply refuse the demands for stricter budgetary controls insisted upon by their Northern counterparts in return for fiscal support. Or Northern European politicians may no longer be able to persuade their voters to head off a sovereign default by one or more of the eurozone’s southern members, such as Italy. We should never underestimate how far Germany’s political establishment is willing to go to save the monetary union, but perhaps COVID-19’s economic fallout of will exceed the capacity of German politicians to agree to transfers.

To be sure, even if no solution can be found within the eurozone, there’s always the possibility that the United States will bail Europe out.

At the worst moments of the eurozone crisis, the U.S. Federal Reserve was there to provide “swap lines” to European banks in need of dollars. The U.S. typically does this for friendly nations, but here more was at stake. During those years, Obama’s Treasury Secretary Tim Geithner had to travel to Berlin to convince the German government to bail out other eurozone countries. A Greek default would have struck a blow to troubled U.S. banks. Back then, it was in the interest of the U.S. to bail out the eurozone.

Will Washington still hold the bag for Europe in the age of “America first” and when, in the event of capital flight, European banks’ needs for U.S. dollars would be even greater? It’s hard to say, but the administration needs to start focusing on the economic news coming out of Europe.

As much as President Trump’s instincts may rebel against support for the EU’s shaky common currency, there will be massive pressure on him to do so, amid calls for “safeguarding global financial stability.” But America should resist the temptation to prop up a wobbly structure.

Italy’s economy is now smaller than before it entered the eurozone, in 1999. Despite years of budgetary surpluses (before interest payments), the Italian government has been unable to jumpstart proper economic growth. Nominal interest rates may be low, but the absolute sums (now repayable in a “hard” currency since Italy gave up the lira for the euro) left over for from terrible financial mismanagement in the 1980s require high taxes, and high taxes are not a recipe for growth. Moreover, the greater the role of the ECB in Italian government financing, the less incentive there is for the Italian government to introduce structural reforms.

The unpleasant reality is that Italy’s public-debt mountain is simply too high to ever be brought down to a manageable size. Even years of “primary budget surpluses,” which exclude interest rate payments, were not sufficient to generate proper economic growth in Italy. Policymakers should accept that an Italian default is the only way out. True, this would hurt investors, pensioners, and the ECB, which holds about 20 percent of Italian debt, but it’s better to deal with the pain now than face even worse damage further down the line.

Would an Italian default lead to the break-up of the eurozone? Perhaps, but if the alternative is preserving a structure that can only be sustained by ever greater debt and transfer payments, perhaps that’s not the worst thing.

To be fair, the potential damage from an Italian default may already be so great that hopes of an orderly debt restructuring and a managed unwinding of the eurozone are nothing more than a pipe dream. In that case, the best option is for European governments to have a “plan B” ready for a disorderly eurozone break-up. According to retired Dutch policy makers close to the decision making at the time, this was something that the Dutch and German governments had in place in 2012.

There is, of course, also always a chance that real economic growth — engendered by the many remarkable technological innovations we are witnessing today — will facilitate enough growth to overcome Italy’s debt mountain, but it would be dangerous to count on it. At its current debt levels, it would take massive growth rates to dig Italy out of its financial hole. And the more difficult it becomes the greater the likelihood of the first, more pessimistic scenario: a disorderly eurozone break-up There may be a rough ride ahead.

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