One of the fundamental ideas behind the European currency union was to create a central bank that would always, at all times, take a hard line on money supply. The euro architects assigned one, and only one, duty to the European Central Bank: keep inflation under control by means of a very strict monetary policy. Under absolutely no circumstances was the ECB supposed to veer from this path of tight money.
This hard-line monetarism earned the ECB a lot of credibility. During the early stages of the Great Recession international investors and lots of economists opined that the euro was going to replace the U.S. dollar as the international standard currency, primarily because of the vast difference in monetary policy. The Federal Reserve was printing money on over time while the ECB was running a very tight ship.
Now the euro is in deep trouble. The dollar is not yet returning as the international standard bearer, but at least the euro crisis has shifted the balance dramatically in the dollar’s favor. What is scaring investors more than anything at this point is investments in euro-denominated treasury bonds. The fear is two-fold: that countries like Greece and Spain are going to exit the euro, re-issue their own currencies and then print money through the wazoo to pay for their deficits; or that, in order to prevent secessions from the euro, the ECB is going to do whatever it takes to save the euro – including printing money like there is no tomorrow.
An article in English in the German magazine Der Spiegel reveals that this is exactly what the ECB is now planning to do:
Interest rates on Spanish sovereign bonds have been rising to dangerous levels in recent weeks. Now, SPIEGEL has learned that the European Central Bank plans to use a new instrument to stop the trend: The bank is considering setting yield targets on the bonds of euro-zone countries. Should interest rates exceed those levels, the ECB would intervene by buying up their debt.
This is nothing short of promising an endless supply of money to the euro zone. In addition to the distorting effects this is going to have on the interest rate as a “risk signal”, this endless credit line is also going to effectively neutralize the austerity demands that the EU, the ECB and the IMF have put in place on, primarily, Greece and Spain. While those programs are destructive in nature, the alternative is not to flood the euro zone with freshly printed money. Which, again, is exactly what the ECB is planning, according to Der Spiegel:
As part of its efforts to fight the euro crisis, the European Central Bank (ECB) is considering establishing caps on interest rates for government bonds in individual countries as part of its future bond-buying program. Under the plan, the ECB would begin purchasing government bonds from crisis-hit countries if yields for those bonds exceeded the interest rates for benchmark German sovereign bonds by a predetermined amount. This would signal to investors which interest rate levels the ECB believes to be appropriate.
This means that the ECB, not the free market, will determine the risk premium on Spanish treasury bonds. Investors will no longer get the return they deem appropriate for putting their money at risk. As a result, demand for bonds from, e.g., Greece and Spain will decline. That in turn will force the Spaniards and the Greeks to raise interest rates even more – which under this new rate cap means that the ECB will have to step in even earlier than desired. They will have to print even more money to keep the troubled euro member states afloat.
In short: the solution exacerbates the problem. As Der Spiegel explains, the ECB does not seem to see it that way:
Given that it can print money itself, the central bank has access to unlimited funds, which could make it extremely difficult for speculators to continue driving yields up beyond the amount stipulated by the ECB. By engaging in bond buying, the ECB not only wants to get the financing costs of crisis-plagued countries under control — it also wants to ensure that the general interest-rate levels across the euro zone do not drift too far apart.
When the euro zone was created the architects of the economic unification wrote a paragraph into the Maastricht Treaty that banned budget deficits beyond three percent of GDP. That paragraph they said, would guarantee that no country ended up with runaway deficits. But as Greece, Spain, Portugal et c have proven, the words in that paragraph were not worth more than the ink they were printed with.
As a result of this fundamental architectural flaw in the currency union, neither the board of the ECB nor the EU leadership is equipped to deal with the crisis. That is why they are now forming a circular firing squad: the EU leadership continues to demand austerity measures from Spain and Greece, intended to close their deficit gaps; the harsh and misguided austerity policies, in turn, are slowly but steadily pushing Greece and Spain toward the euro exit door; simultaneously, the ECB will now do its best to keep these countries in, by flooding them with stacks of freshly minted euros. As a result, Greece, Spain and Italy can use the new money supply to continue to borrow, i.e., to escape the austerity policies and stay in the euro. Instead of them seceding from the euro or closing their deficits through structural reforms to their welfare states, they now have an opportunity to stay in and live off an endless cash commitment from the ECB.
Der Spiegel reports that the ECB leadership appears to be aware of the consequences of their own open-ended commitment:
In an interview with state-owned news agency EFE, Spanish Economics Minister Luis de Guindos called for the ECB to purchase unlimited amounts of Spanish sovereign bonds on the capital markets. He argued that that would be the only way to effectively reduce interest rate pressure on Spanish sovereign bonds and to eliminate doubts about the euro. ECB President Mario Draghi has signaled the prospect of the ECB undertaking that kind of step, but only under the precondition that countries such as Spain or Italy first make a formal request for EU aid, which would involve agreeing to the conditions attached to that assistance. The question of what a country would have to do in return for the ECB buying its bonds is expected to be discussed at a meeting of Euro Group finance and economics ministers that is scheduled for the second week of September, de Guindos said.
This is interesting, because it means that Spain and other troubled euro countries would be able to negotiate more lenient deals with the ECB under this plan than they currently have with the EU. In other words, they would be able to relax their austerity policies and get a virtually unlimited line of credit at the same time.
If this actually becomes the policy standard for the euro zone, it means that its member states have surrendered to the fiscal behemoth that caused the deficit crisis in the first place: the welfare state. They will de facto have admitted that the only solution to the fiscal problems in countries like Spain and Greece is politically too difficult to deal with. Instead they choose to slowly but steadily erode their common currency and to replace destructive austerity policies with an even more destructive open monetary commitment.
Fortunately, there is some resistance within the euro zone to this from-bad-to-worse kind of policy shift:
In Germany, however, leading politicians within Chancellor Angela Merkel’s coalition government — which includes the conservative Christian Democratic Union (CDU), its Bavarian sister party the Christian Social Union (CSU) and the business-friendly Free Democratic Party (FDP) — reject any additional bailout packages for Greece beyond the two that have already been approved. Volker Kauder, the head of the joint CDU and CSU party group in the federal parliament, the Bundestag, told SPIEGEL: “The Greeks must abide by what they’ve agreed to.” And on Saturday, German Finance Minister Wolfgang Schäuble also rejected further financial aid for Greece. “We can’t put together yet another new program,” he said. “It is not responsible to throw money into a bottomless pit.”
We will have to see where this ends. Clearly, the ECB has its own skin in the game – in fact, its very survival is on the line. If the euro starts falling apart, then where will it stop? That government entity will do everything in its power to survive. Which means, it will do a lot. Eventually, this may actually come down to a political showdown between the ECB and the German government, though that is still a bit far down the road. But with growing resistance in Germany toward more Greek bailouts, there will also be increasing resistance toward any ECB mismanagement of the euro. The Germans will return to the Deutsch Mark before they let the ECB print money and reduce the euro to drachma standards.
At any rate, the European crisis is not over yet. On the contrary: the biggest drama is yet to come.