The eurozone is in serious trouble and Greece is just a symptom. Whether or not they default on their debt may not matter as similar problems plague Spain, Ireland, Portugal, and even Italy. The European Monetary Union is built on a house of cards and they don’t have the time for needed radical reforms. Like all sovereigns who owe more than they can pay, they will resort to monetary inflation to bail themselves out. This article explains how the EMU works, why it is failing, and why they will resort to fiat money printing to solve it. This is Part II. For Part I, go here.
There is a serious debate going on between Germany and the rest of the EU. You would guess right that Angela Merkel is getting a lot of heat from her fellow Germans about the bailout. The Germans want debt reductions (haircuts) from Greece’s bankers. Or at least they would like an extension of the maturities. Which means they don’t want to stick German taxpayers with the entire bill.
The ECB and the IMF do not want this because it would amount to a de facto default by Greece. This is not a small problem. It is a huge problem. If it were only Greece, then it would be a minor issue. They are afraid such a default would start a chain reaction of defaults (euphemistically called a “credit event”) by Greece’s fellow PIIGS, especially Ireland and Spain. The ECB said last week:
The risk of “adverse contagion” from the bloc’s sovereign debt crisis, and its interplay with the financial sector, “arguably remains the most pressing concern.” European-level efforts to contain the debt crisis “have not been sufficient,” and European crisis management has been “fraught with some detrimental shortcomings.”
In other words, if Greece defaults, the market for euro denominated government bonds would possibly collapse and the losses would be enormous. Here is a picture of the debt structure of major economies as a percentage of GDP, including the PIIGS:
What is the real fear behind this? The stability (and bailout) of their banks who have invested massively in government bonds of the PIIGS. Here are some charts on banks exposures:
This exposure concerns the ECB and national bank regulators because their banks are highly leveraged:
If these banks get into trouble, who will bail them out? The article from which the above chart was taken (Fortune) likened the problem to Lehman which pre-Crash had 30:1 leverage. The German taxpayers would not only bail out their own banks but also would be on the hook for propping up Greece, et al. If you wish to see a list of the top 40 banks in terms of exposure to a Greek default see here.
So, what will happen?
The problem as I mentioned at the beginning of this article is the European Monetary Union and the concept of the euro itself. All the safeguards of the Maastricht Treaty establishing the European Monetary Union and the ECB have been tossed aside as they try to save the system. The “no bailout” rule, the ECB independence mandate, the prohibition of deficits of more than 3% of GDP, the prohibition of debt exceeding 60% of GDP, the prohibition on ECB purchases of member sovereign debt, have all been ignored during this crisis.
Instead the ECB has been a massive fiat money pumping machine that has served the needs of its client nations to borrow and spend. Here’s how it works:
When governments in the EMU run deficits, they issue bonds. A substantial part of these bonds are bought by the banking system. The banking system is happy to buy these bonds because they are accepted as collateral in the lending operations of the ECB. This means that it is essential and profitable for banks to own government bonds. By presenting the bonds as collateral, banks can receive new money from the ECB.
The mechanism works as follows: Banks create new money by credit expansion. They exchange the money against government bonds and use them to refinance with the ECB. The end result is that the governments finance their deficits with new money created by banks, and the banks receive new base money by pledging the bonds as collateral.
This is what the Greeks did and as a result they exported inflation, including price inflation, to the rest of the eurozone. They ran a deficit financed by eurozone banks, the banks were allowed to use the bonds as Tier 1 capital, and the ECB expanded money and credit to accommodate them. The Greeks got something for nothing from the fiat money expansion, exported price inflation to the eurozone, and as prices went up, the suckers at the end of the money chain paid more for the same things.
The costs of the Greek deficits were partially shifted to other countries of the EMU. The ECB created new euros, accepting Greek government bonds as collateral. Greek debts were thus monetized. The Greek government spent the money it received from the bonds sale to win and increase support among its population. When prices started to rise in Greece, money flew to other countries, bidding up prices in the rest of the EMU. In other member states, people saw their buying costs climbing faster than their incomes. This mechanism implied a redistribution in favor of Greece. The Greek government was being bailed out by the rest of the EMU in a constant transfer of purchasing power.
This is a house of cards. The Maastricht Treaty established that the ECB cannot make loans to banks without certain defined collateral. Specifically, for this bailout they can’t accept Greece’s bonds as collateral if Greece has been declared to be in default. Thus the current argument between Germany and the ECB about haircuts and extensions. Both S&P and Moody’s have said they would treat haircuts and extensions as a default. S&P just cut Greece from B to CCC, and Moody’s to Caa1. Such ratings are defined as meaning that there is an even chance that Greece will default.
There are two ways out of this mess: default or monetary inflation. They could unwind the EMU and ditch the euro, but that is unlikely to happen in the near term.
My guess is that they will print their way out of this mess. Continental governments have very little stomach for mass unrest since it has a tendency to bring down governments, bring in more radical regimes, and create uncertainty in Europe. They have already pledged another €750 billion in stand-by bailout money to the other PIIGS. That will be used up and perhaps more.
The eurozone powers are crossing their fingers and waiting for something good to happen. With various economic signs pointing down in the U.S. and in the rest of the world, this only puts greater pressure on the euro and their debt problem. This week red flags were raised about the German economy, the powerhouse of the EU. There won’t be an economic recovery to save them.
Relying on monetary inflation is a traditional way for governments to get themselves out of debt. A 7% rate of inflation could reduce the amount of debt owed by these sovereigns by about one-third in just five years.
That is just too tempting for the EU to pass up.