The Greek Crisis: Why Super Mario Draghi Can’t Save Europe
Mario Draghi, president of the European Central Bank (ECB), speaks at a conference in Berlin, Germany. Photo by Sean Gallup via Getty Images.
While readers of Making Sen$e and the Rundown know Larry Kotlikoff as our resident Social Security guru (he answers questions as “Ask Larry” every Monday), he has an ample list of other credits in economics. So when he asked if we’d allow him to weigh in on the Euro crisis, we were only too happy to oblige. As you’ll see if you read this to the end, Larry manages to build to a climax featuring his policy hobby-horse of the past few years: Limited purpose banking.
You can read a response to this post later today from another economist, the former Finance Minister of Greece and currently Minister for the Environment, Energy and Climate Change, George Papaconstantinou.
European Central Bank (ECB) Chairman Mario Draghi has a very big agenda. Armed with only a printing press, he’s pledging to directly bail out the GIIPS (Greece, Italy, Ireland, Portugal and Spain) and indirectly bail out their economies.
Draghi’s betting his commitment will give private lenders the confidence needed to invest in the GIPPS as well. But even if they don’t, he says he can go it alone without causing inflation.
From Draghi’s perspective, printing money to buy bonds is simply doing what banks do: they borrow; they lend. Each time he prints (electronically creates) new euros and uses them to buy bonds, the new euros show up on the ECB balance sheet as liabilities owed to the public, while the bonds purchased are recorded as assets.
The new euros are, indeed, liabilities. Putting them in circulation either raises prices or keeps prices from falling as fast as they otherwise would. Either way, the public ends up with less purchasing power, and it is this purchasing power that Draghi borrows from the public.
“But,” he says, “I’m buying solid assets with these borrowed resources, so the Euro-public will, through the ECB, own assets worth exactly what it surrenders in purchasing power.”
But what if Draghi overpays? In this case, he redistributes money from the public to those who sell him the bad assets. Since 2008, Draghi has printed over €1.5 trillion and bought an almost equal quantity of Eurozone government and bank assets of relatively low quality.
The concern is that Draghi will pay too much for too little and transfer, on an ongoing basis, vast quantities of real resources from the haves (Germany, et al.) to the have-nots (the GIIPS). It is not, however, a concern that Draghi shares. He pledges to make his loans to sovereigns conditional on IMF-approved fiscal and structural reform and the GIIPS’s acceptance of a new EU banking supervisor to discipline their private banks and non-bank customers.
And if inflation takes off? “No worries,” says Super Mario, as he’s now being called. “In this case, the ECB will simply sell its solid assets back to the private sector, thereby extracting our euro injections and returning prices to their former levels. Alternatively, we can pay higher rates on reserves and, thereby, keep the injected money in the banks and out of the economy’s blood stream.”
My preferred nickname for the intrepid chairman is “But Mario!” because his confidence game raises six big buts.
But No. 1: Draghi’s various supplicants have huge holes in their balance sheets, which even the best future behavior and most favorable macroeconomic scenario won’t close. Instead, Draghi has signed up to fill the holes. Eurozone banks are, collectively, short €1.8 trillion. Add in likely debt relief of €1 trillion to GIIPS governments and we’re talking a year of German GDP. If that’s even half right, Draghi has to deliver tons of euros in exchange for, well, nothing. Printing another €1.8 trillion on top of the €1.5 trillion already printed could trigger Germany’s 89-year nightmare — hyperinflation.
But No. 2: Under the ECB’s T2 reserve-sharing mechanism, GIIPS central banks have an unlimited line of credit on the Bundesbank and other central banks experiencing capital inflows. Hence, GIIPS central banks can effectively force the Bundesbank, et al. to lend to GIIPS banks, non-banks, and households. They’ve already forced the Bundesbank to make €750 billion in such loans, with this figure growing €30 billion per month! If the euro breaks up, Germany can kiss this “investment” goodbye.
But No. 3: Germany retains a veto over the European Stability Mechanism (ESM), and Draghi says he will only purchase sovereign bonds in the context of ESM participation. So Germany can pull the plug on Draghi’s confidence game whenever it wants.
But No. 4: Draghi’s muddle-through policy differs little from the past six years of muddle-through that’s left the GIIPS with horrendous unemployment, an imminent recession, a massive and accelerating bank run, and tremendous private-sector uncertainty. According to IMF Chief Economist, Olivier Blanchard, muddle-through could take 15 years to work.
But No. 5: Total GIIPS debt is €3 trillion. And the non-deposit liabilities of the GIIPS banks total $5 trillion. If the private sector doesn’t roll over these borrowings, the ECB must. That’s a huge amount of euros to create.
But No. 6: Yes, the ECB has liquid foreign assets that it can sell into the market to suck out new euros it injects into the market. But these assets are limited. They total at most €1.5 trillion at most. Also, paying interest on reserves to keep the banks from lending euros into the markets has its limits. If every euro printed were held as reserves by banks, the banks would no longer be intermediating. They would simply be warehousing the public’s money.
Taken together, these buts — as well as the opacity of GIIPS government and bank balance sheets — provide plenty of private investors plenty of reason to steer clear of the GIIPS, thereby producing not just zombie banks, but also zombie countries. If Super Mario wants to earn his title and really restore confidence, he needs to go beyond “Trust me” to “Watch this.” I.e., he has to change the facts on the ground, immediately and permanently.
Doing so requires several things. First, he needs to orchestrate partial, but significant defaults on GIIPS debt that leave the GIIPS fiscally solvent even if their economies take years to recover. Second, he needs to mark all GIIPS banks to market, imposing haircuts on non-depository creditors. These two bold steps will make clear that the investors in risky bonds and risky banks, not the general public, will take the hit for what turned out to be bad investments. It will also verify that fresh euros are not freely available to bad investors with all the long-term inflation risks that entails.
Draghi also needs to move Europe’s opaque and extremely leveraged banking system as quickly as possible to a transparent, 100 percent equity-financed mutual fund financial system — what I call “Limited Purpose Banking.” I’ve explained this system before here on Making Sen$e.
The steps to implement LPB are:
First, to swap the re-marked bank debt for equity shares in mutual funds while simultaneously selling the remarked bank assets to the mutual funds.
Second, to require all other financial corporations to operate as 100 percent equity-financed mutual funds.
Third, to establish an independent agency to verify and disclose all securities bought, sold, and held by the mutual funds, so the world can see precisely what it’s buying when it purchases Eurozone mutual fund shares.
This new financial system is called Limited Purpose Banking because it restricts banks to intermediating on a transparent, non-leveraged basis. It would end the Eurozone crisis overnight and kickstart the GIIPS economies. Indeed, with a banking system that’s transparent, has zero leverage, and can never fail, and with governments that can pay their bills and that will never have to leave the euro to bail out their banks, Draghi will provide for sure what is now just a pipe dream — a real vote of private financial-sector confidence.
Laurence Kotlikoff is an economist at Boston University, the resident Social Security expert on the NewsHour’s Making Sen$e page, and author of “Jimmy Stewart Is Dead” and “The Economic Consequences of the Vickers Commission,” among many other books. You can see his voluminous output at http://www.kotlikoff.net/.
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As usual, look for a second post early this afternoon. But please don’t blame us if events or technology make that impossible. Meanwhile, let it be known that this entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions