A Giant Game of Chicken in the Eurozone

As financial operatives and politicians play games to protect their interests, the future of ordinary Europeans is held hostage.

The Europeans evidently thrive on instability and the ongoing threat of systemic risk. There is nothing else to explain the renewed hardline stance adopted by both Mario Draghi of the ECB and the German government on fiscal policy, just as the markets appeared to be calming down again.

In response to the question as to whether Greece was a “one-off”, or a deal which would presage similar claims on the part of the other Mediterranean debtor nations, there has been a growing prevailing belief that either the terms demanded of Greece would be so punitive (“pour decourager les autres”) or that, if Greece were to default, a sufficiently large firewall would be constructed by the Troika to ensure that the contagion wouldn’t extend to other countries. This is what Greek economist Yanis Varoufakis has called “cauterize and print”:

"Germany’s belated epiphany is that, without a major redesign of the euro architecture, a number (>1) of eurozone member states are irretrievably insolvent. As for the two strategic choices, the first is Berlin’s conclusion that German politics have no stomach for, or interest in, a structural redesign of the euro system.[2] The second choice involves a massive bet in attempting to save the eurozone by shrinking it forcefully while, at the same time, authorising the ECB to print trillions of euros to cauterise the stumps left when the states earmarked for the chop are severed."

Well, the 2nd leg of that strategy seems to be falling apart, even as Greece is slowly being severed from the euro zone (because let’s be honest: Greece has insincerely accepted yet more impossible conditions for implementing another unworkable fiscal adjustment plan, which suggests that both sides are simply playing for yet more time). 

In the meantime, the UK’s Daily Telegraph has reported that Germany's ruling parties are to introduce a resolution in parliament blocking any further boost to the EU’s bail-out machinery, vastly complicating Greece’s rescue package and risking a major clash with the International Monetary Fund. According to Ambrose Evans-Pritchard

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“'European solidarity is not an end in itself and should not be a one-way street. Germany’s engagement has reached it limits,' said the text, drafted by Chancellor Angela Merkel’s Christian Democrats and Free Democrat (FDP) allies.
“'Germany itself faces strict austerity to comply with the national debt brake,”'said the declaration, which will go to the Bundestag next week. Lawmakers said there is no scope to boost the EU’s 'firewall' to €750bn, either by increasing the new European Stability Mechanism (ESM) or by running it together with the old bail-out fund (EFSF)."
In one sense, the sentiment behind the draft is right. European solidarity should not be a one-way street. But that’s exactly the nub of the issue: As with all of the “rescue plans” introduced thus far, the latest does not allow the Greek government to help its people cushion the blow from 5 years of depression, but simply provides a mechanism to bail out banks and bondholders. Invoking Aesop’s famous fable about the ants and the grasshoppers, Yanis Varoufakis describes the crux of the problem:
“The problem (for those seeking to understand a Crisis) with attractive allegories is that the latter can be as much of a help as a hindrance. In this post I wish to argue that Aesop’s timeless tale, however appropriate it may seem at first glance, contributes more to Europe’s current problems than to their solution. My reason is simple: The ants and the grasshoppers are to be found in both Greece and in Germany, in the Netherlands and in Portugal, in Austria as well as in neighbouring Italy. But when we assume that all the ants are in the north and all the grasshoppers in the south, the remedies we introduce are toxic.
Yes, it is true, the Crisis has placed a disproportionate share of the burden on the back of Europe’s ants. Only Europe’s ants are not exclusively German or Dutch or Austrian; and nor are the grasshoppers exclusively Greek, Iberian or Sicilian. Some ants are German and some are Greek. What unites Europe’s ants, north and south, east and west, is that they struggled to make ends meet during the good times and they are struggling even more now during the bad times. Meanwhile, the grasshoppers, both in the north and in the south of Europe, lived the good life before the Crisis and are doing fairly well now, keen as always to privatise the gains and distribute the pain (to the ants).”
That message evidently has not got through to either the Merkel government or the Bundesbank. The proposed draft of Merkel’s government is a political response to mounting German frustration at the current direction of European Union economic policy. There is, however, no corresponding appreciation that her coalition is fomenting this very anger through the ongoing perpetuation of a failed fiscal policy response which, as Varoufakis notes, continues to rewards lazy grasshoppers in both Germany and the south, whilst making all of Europe’s ants work harder and harder for less and less. It is perfectly understandable as to why ordinary German citizens, as well as those in other parts of the EU, should question why all of their hard work is not translating into a better life, when “their money” is actually going down a sinkhole to fund insolvent countries given no means of growing themselves out of debt trap dynamics.

By the same token, left without the lever of a countercyclical fiscal growth policy, the ECB has responded somewhat grudgingly with an escalating and rapidly expanding balance sheet, which has the Weimar hyperinflationistas up in arms, but at least has prevented the whole system from blowing up. Even Germany’s erstwhile allies, the Finns and the Dutch, are prepared to countenance an increase in the EU firewall to €750bn as they are beginning to appreciate the dangers of heading non-stop toward the iceberg.

But while Germany’s erstwhile allies are backing off their hardline fiscal austerity somewhat, the IMF has hinted that it may cut its share of Greece’s €130bn (£110bn) package and warned that its members will not commit more in funds to ring fence Italy and Spain unless Europe itself beefs up its rescue scheme. The Fund has argued (rightly) that the Europeans have more than adequate resources to create a sufficiently large firewall, and that further recourse to the IMF is, in fact, totally unnecessary.

The US Treasury seems to agree with the IMF’s assessment, already indicating that it is unprepared to contribute more to the Fund’s resources. The Treasury is also right, given that the ECB has the capacity to create infinite euros to deal with any looming solvency issues. 

We therefore have the makings of a giant game of chicken: The IMF is nervous about its share of Greek bailout and its broader EU exposure And the Germans won't expand the firewall without a bigger IMF contribution because they want the IMF as their prime counterparty risk, NOT the ECB. This looming impasse probably also explains why ECB President Mario Draghi is starting tosound so Prussian againby pushing the line that the Mediterranean periphery has to cut living standards because it has been living beyond its means. While acknowledging that “there has been greater stability in financial markets” over the past several weeks, Draghi completely ignores the constructive role played by the ECB in creating this stability and instead ascribes it all to renewed commitments of fiscal discipline on the part of all of the euro zone’s members:
“Many governments have taken decisions on both fiscal consolidation and structural reforms. We have a fiscal compact where the European governments are starting to release national sovereignty for the common intent of being together. The banking system seems less fragile than it was a year ago. Some bond markets have reopened.”
The new head of the ECB is, we presume, an intelligent man, so one can only assume that he is being disingenuous in the extreme here. The renewed stability in the financial markets has NOTHING to do with fiscal consolidation and everything to do with the expansion of the ECB’s balance sheet. The consolidated assets of the European system of Central Banks are now 4.4 billion euros or $5.7 billion. In effect, the consolidated ESCB balance sheet has grown exponentially, and its increase over the last 6 months is almost equal to the entire increase in the Fed’s balance sheet over the last several years.

In contrast to his public statements suggesting institutional and legal limits in terms of what the ECB cannot do, Draghi has been using the bank’s balance sheet far more aggressively in order to prevent a banking meltdown and combat the EMU’s ongoing solvency crisis (a product, as we have indicated many times before, of the euro zone’s flawed financial architecture). And he has done so whilst (until this point) keeping Germany onside. Of course, one could argue that in reality all the ECB is doing is providing lending to the likes of Italian (or Greek, or Spanish) banks so they can pay German exporters and transfer deposits fleeing to Germany (or Switzerland)!

That perverse effect aside, Draghi has hitherto been able to carry out his operations with the quiescence of the Germans, who have presumably remained relatively quiet, whilst the Greek negotiations were being conducted (although that didn’t stop Finance Minister Wolfgang Schauble from lobbing a few rhetorical grenades via the press, hinting that it might be better if Greece were to default outright rather than take the deal on offer). But nobody else has said anything for fear of jeopardizing the deal on the table (which will almost certainly become a source of fresh contention for the other Mediterranean periphery countries, as they will almost certainly begin to ask for comparable haircuts on their own debts).

What is the source of this German angst? They worry, particularly the Bundesbank, that they have a credit with the ECB, not with the PIIGS countries. But they are concerned that the ECB now has low-quality collateral so this is risky if the ECB ceases operations (although why this should happen is unclear as the ECB can never run out of euros).

Hence the BUBA desire for the IMF, as a counterparty, even though the IMF itself is a political fig-leaf, given that the Fund’s “special drawing rights” are drawn directly from each of the central banks. In other words, the IMF gets its euros from the ECB, although by standing in the middle of the transaction, Germans can happily pretend that their counterparty risk lies with the IMF, and that they will therefore get repaid (and if this means involving the Fed, the Bank of Japan, Bank of China and Bank of England, so much the better).

The IMF, under Christine Lagarde, is evidently getting tired of playing this game, so it has refused to ask for more funding to deal with the euro zone’s ongoing crisis, in effect putting the ball back into Mr. Draghi’s court, who in turn has to deal with the Bundesbank. Hence, the renewed public relations campaign on behalf of “responsible” fiscal policy and the “new and improved” Stability and Growth Pact:

[I]t is encouraging to see that important steps have recently been taken … strengthens both the preventive and the corrective arm of the Stability and Growth Pact and establishes minimum requirements for national budgetary frameworks … a new ‘fiscal compact’ with a view to achieving a more effective disciplining of fiscal policies. Major elements of the fiscal compact are the strengthening of the role of the balanced budget rule and a further tightening of the excessive deficit procedure. It is of utmost importance, that the rules are now fully implemented in the spirit of this agreement. All these measures aim to ensure that individual countries live up to their responsibilities to bring their public finances in order.

As Bill Mitchell wryly observed: “The EMU is in the worst downturn for 80 years and its only ‘response’ is to make it worse because it has introduced voluntary rules that require nations in deep aggregate demand shocks to inflict further spending cuts.” Austerity in the euro zone has consisted of public spending cuts and tax hikes, which have both directly slowed the economies and increased net savings desires, as the austerity measures have also reduced private sector desires to borrow to spend. This combination has resulted in a decline in sales, which translates into fewer jobs and reduced private sector income, which further translates into reduced tax collections and increased public sector transfer payments, as the austerity measures designed to reduce public sector debt instead serve to increase it.

My bet is the IMF ultimately folds and commits more, because even the Fund recognizes the stupidity of imposing pro-cyclical fiscal policy in the midst of a recession, but not until the European markets begin to fail again and systemic pressures become more acute. Either way you have to congratulate the Germans for an exceptional game...with a weak hand they have everyone running around while they" mercant" their way to growth and others support the casualties they throw on the fire....
Marshall Auerback is a market analyst and commentator.