In a perceptive analysis written three years ago Yannis Varoufakis argued that ‘Europe needs a hegemonic Germany’, that like the USA did in relation to global capitalism after WWII Germany needed to take control and manage the entire European economy but in order to deliver the required hegemonic leadership Germany needed to move beyond its own limited self interest and take responsibility for making the whole system work. Germany needed to shift from panicky authoritarianism to a hegemonic strategy based an enlightened self-interest. Unfortunately Germany shows no signs of taking on a hegemonic role and persists in pushing proposals and policies that are based on an ultimately self defeating narrow self interest.
In recent weeks, Germany has put forward two proposals for the ‘future viability’ of the of the single currency. At first, both proposals (detailed below) might appear to be constructive and positive proposals. Some sort of European level sovereign debt restructuring mechanism, and a pan-European fiscal system are what many eurozone reformers have been advocating for years. In fact these flawed proposals risk a dangerous destabilisation of the European banking system, especially in the weaker periphery that, if approved, would radically alter the nature of the currency union.
For the worse.
The context
These new proposals follow the German led reworking of the EU banking union which came into effect on January 1st 2016 and which means that the new system of bank regulation will reduce rather than increase stability (see “The EU’s banking union is a recipe for disaster”). One of the features in the new banking union directives is mandatory haircuts for private investors and depositors if a bank goes bust, these new regulations mean that investing in, or depositing any substantial savings with, a wide range of weaker banks mostly located in the eurozone periphery has suddenly become much riskier. The predictable result has been capital flight from the periphery to the core of the eurozone. The banking union’s bail-in rule is already causing a slow-motion bank run on periphery banks, with periphery countries experiencing large scale capital flight towards core countries (almost on par with 2012 levels), as bondholders and depositors flee the banks of the weaker countries in fear of looming bail-ins, confiscations, capital controls and bank failures of the kind that we have seen in Greece and Cyprus.
Germany’s first proposal: changing the status of sovereign debt
The first proposal, already at the centre of high-level intergovernmental discussions, comes from the German Council of Economic Experts, the country’s most influential economic advisory group (sometimes referred to as the ‘five wise men’). It has the backing of the Bundesbank, of the German finance minister Wolfgang Schäuble and, it would appear, even of Mario Draghi President of the European Central Bank.
Apparently aimed at ‘severing the link between banks and government’ (just like the banking union) and ‘ensuring long-term debt sustainability’, it calls for:
The immediate effect of the proposed changes in sovereign debt ratings coming into force would be to open up huge holes in the balance sheets of the banks of the ‘riskier’ countries (at the time of writing, all periphery countries except Ireland have a Standard & Poor’s rating of BBB+ or less), since banks tend to hold a large percentage of their country’s public debt. Banks can only operate if their balance sheets do actually balance, that is if the value of their assets broadly match the value of their liabilities. Banks usually hold a significant amount of government bonds as a major core asset holding, especially the bonds of their own national governments, because such bonds have traditionally held their value well, as they have been rated as almost risk free, and are usually highly liquid (i.e easy to sell). For example in the case of a country like Italy, where the banks own around 400 billion euros of government debt and are already severely undercapitalised, the effects on the banking system of reducing the value and rating of a huge chunk of their asset portfolio would be catastrophic.
The proposed measure, far from ‘severing the link between banks and government’, would almost certainly ignite a new European bond crisis, of which we are already witnessing the first signs, as banks rush to offload their holdings of ‘risky’ government debt in favour of ‘safer’ bonds, such as German ones (as the German Council of Economic Experts report acknowledges, ‘as a result of the risk-adjusted large exposure limit, there is more leeway for holding high-quality government bonds than with a fixed limit’). The report estimates that if the proposals from the German Council are implemented banks will have to divest around 600 billion euros of government debt.
Sovereign bonds have a unique and pivotal role for the financial systems of the euro area. So, once sovereign bonds in some euro-area countries become more risky, the whole financial system might turn frail, affecting growth and economic stability. Ultimately, rather than exerting sound discipline on some member states, the new regime could widen bond rate differentials and make debt convergence simply unattainable, increasing the probability of a euro-area break-up.
As noted by the German economist Peter Bofinger, the only member of the German Council of Economic Experts to vote against the sovereign bail-in plan, this would almost certainly ignite a 2012-style self-fulfilling sovereign debt crisis, as periphery countries’ bond yields would quickly rise to unsustainable levels, making it increasingly hard for governments to roll over maturing debt at reasonable prices and eventually forcing them to turn to the ESM for help, which would entail even heavier losses for their banks and an even heavier dose of austerity (which is the main reason that periphery banks are in such a terrible state in the first place).
It would essentially amount to a return to the pre-2012 status quo, with governments once again subject to the supposed ‘discipline’ of the markets as if the 2011-12 sovereign debt crisis hadn’t made it clear that financial markets are just as incapable of efficiently assessing and managing the public finances of countries as they are of disciplining or correcting themselves (which, of course, is why Draghi was ultimately forced to intervene with his Quantitive Easing bond-buying program). ‘We can’t allow a regime where markets are masters of governments… It [would be] the fastest way to break up the eurozone’, says Bofinger.
The scenario foreseen by Bofinger is arguably already under way: in recent weeks the yields on Italian, Spanish and especially Portuguese government debt have started surging again for the first time since 2012, reviving fears of the sovereign ‘doom-loop’ that ravaged the region four years ago (see my article ‘Too big to bail – how the banks crashed the eurozone’ for an explanation of the ‘doom-loop’).
Germany’s second proposal: a eurozone Finance Ministry
The second proposal, initially put forward by Schäuble and fellow high-ranking member of the CDU party Karl Lamers and revived in recent weeks by the governors of the German and French central banks, Jens Weidmann (Bundesbank) and François Villeroy de Galhau (Banque de France), calls for the creation of a ‘eurozone finance ministry’, and an accompanying ‘independent fiscal council’.
This second German led proposal, for the creation of a ‘eurozone finance ministry’ and an ‘independent fiscal council’, is as flawed and dangerous as the proposed changes to the ratings of sovereign bonds. The only way the eurozone can survive, and more importantly deliver stability, growth and prosperity, is through some sort of substantial fiscal union. And a fiscal union would require some sort of political union. So a real eurozone finance ministry based on a real fiscal union would require as an absolute minimum tax-raising powers at the eurozone level in the order of at least 10 per cent of the eurozone’s GDP; permanent fiscal transfers from richer to poorer countries; a federal authority with the capacity to engage in deficit spending; the support of the ECB in the operation of fiscal policy including deficit financing. If such a substantial and important part of the governance of the lives of the eurozone citizens were to be transferred to a eurozone level finance ministry then it would be essential that such a powerful government structure was under real democratic control. This would require a proportionate transfer of democratic legitimacy, accountability and participation from the national to the supranational level.
Unfortunately, the fiscal union proposed by Weidmann-Villeroy, and by Schäuble- Lamers is very different: it revolves around the creation of a European ‘budget commissioner with powers to reject national budgets ‘if they do not correspond to the rules’, in Schäuble-Lamers’ own words, but doesn’t foresee the creation of a federal institution with legislative and spending powers. This would subject the EMU to an even tighter deflationary, contractionary and mercantilist straitjacket, effectively depriving member states of whatever small leeway they would have left under the current rules to respond to another (likely) financial crash, and with no mechanism for democratic control or a democratically authorised change of policy. Transferring budget making powers to a non-elected body would be tantamount to the end of democracy in the eurozone, because if the politicians you vote for are legally and administratively blocked from changing taxation and spending policies then democracy has ceased to function. It’s not hard to see why such a development would be not only economically self-defeating but politically destabilising as well.
What is Germany up to?
Given that both the German plans, the change of status of ‘weaker’ sovereign debts and the creation of a European budget commissioner, would further deepen the internal imbalances inside the eurozone, and would thus block the eurozone economy from escaping from stagnation and low growth, and would in fact inevitably lead to the further impoverishment of the southern periphery, why is Germany making such proposals? Why is Germany pursuing so vehemently two proposals that are bound to increase the internal imbalances of the eurozone and thus increase the likelihood of a break-up of the monetary union? There are a number of hypotheses to explain the German approach.
One possible explanation is that the German political establishment does not believe in the viability or desirability of the currency union anymore (in its current form at least) and is therefore either (i) planning for what it considers to be an inevitable outcome (by inflicting as much damage as possible to its potential competitors, for example) or (ii) deliberately creating a situation so unsustainable that periphery countries will have no choice but to exit. Certainly Schäuble made clear during the last round of the Greek crisis in 2015 that he wanted Greece out of the eurozone. His view, shared by many in the German elite is that far too many weak countries were allowed into the single currency for political reasons and that given, in their view, Germany’s reasonable refusal to transfer wealth to the periphery or indulge in a Keynesian reflation, the best thing is to get the pain out of the way and drastically reduce the size of the eurozone. The desire to create a German led ‘Kerneuropa’ (core Europe) has been a feature of German political discourse for decades and the underlying assumption is that this ‘Kerneuropa’ would be built on German principles (i.e it would replicate the German model). In this context the UK becoming a semi detached member of the EU, as a result of the Cameron package, ceases to be problematic. Instead the EU becomes a strong and smaller German core with various less integrated concentric rings around it.
Yet another possibility is that because Germany benefits the most from monetary union, and given the hold of Ordoliberal ideology in Berlin and Brussels (see ‘Ordoliberalism and the European Project’ which explores the role of Ordoliberalism in the European project) the German elite is simply blinded to the fact that it is sowing the seeds of the eurozone demise. Given the depth of the commitment amongst the German elite to the current economic and policy model it is more likely that Germany would leave the eurozone than see it run and structured in an entirely different way. Any hint of a eurozone Keynesian deficit spending policy and the Germans would be off.
German Chancellor Angela Merkel, in an interview aired by Deutschlandfunk radio in 2011 offered a perfectly Ordoliberal view of the situation. In the interview she explained how democracy in the eurozone must be a ‘market-conforming democracy’.
“Of course we live in a democracy and it is a parliamentary democracy, and therefore the right to set the budget is a core right of the Bundestag, so we shall find ways to shape parliamentary co-determination so that it nonetheless conforms to the markets.”
A third hypothesis is that Germany is pursuing an explicit realpolitik strategy of continental domination in the knowledge that because of the commitment of the European political elites to monetary union it will almost certainly not implode, regardless of how bad the situation gets in the European periphery. Partly because the EU establishment will always be ready to do ‘whatever it takes’ to save the euro, partly because periphery countries continue to be governed by parties wedded to the euro ‘whatever the case’. This is arguably the most disturbing scenario of all, since it implies if the current eurozone system persists the European periphery, particularly in the south, would suffer decades of depression and decline as the entire Southern bloc is reduced to the impoverished hinterland of Germany’s new economic empire. This process of ever deeper divergence between the core and the periphery has been dubbed ‘mezzogiornification’.
It is worth noting in the context of considering a possible German realpolitik strategy that the recently introduced new EU banking union system, the German proposals on the change of status of sovereign debt and the proposed a European budget commissioner would all have a similar effect: i.e. capital would flow out of the periphery and into the EU core, and that means most of the capital would flow into Germany.
The financial situation in the eurozone is deteriorating
The failure to address the deep design flaws of the eurozone system after the 2010-12 crisis and the fact that what reforms have been proposed or implemented are actually making matters worse not better, means that the crisis of the eurozone has never really gone away. Following the violent gyrations and crises of 2010-2012 recent years have been calmer, but most observers have expected that it was only a matter of time before the eurozone once again faced an existential crisis. Now there are signs that the single currency is entering a new phase of crisis. The first and most important sign of distress in the eurozone is the return of the ‘toxic twins’: the interaction between banks and their sovereigns. The crash in bank share prices at the beginning of February coincided with an increase in bond yields in the eurozone’s periphery. The pattern is similar to what happened during 2010-12. The sovereign bond yields have not quite reached the same dizzy heights, though Portugal’s 10-year yields are almost 4 per cent.
The combination of high bond yields, persistently high public and private sector debt and low growth rates is clearly unsustainable. Italy’s position may be better than Portugal’s but it is still not sustainable. Italian 10-year yields rose to more than 1.7 per cent; German yields are a little over 0.2 per cent. The gap, or the spread, is the metric of stress in the system, which is rising again.
The financial markets are telling us that they are losing faith in Mario Draghi’s pledge of 2012 when he promised to do “whatever it takes” to defend the member states of the eurozone against a speculative attack. With this promise the ECB president ended the first phase of the eurozone crisis, but did so at a cost. The urgency to resolve the underlying structural problems suddenly disappeared.
The second message the markets are sending is that Europe’s banking union has failed. The banking union the EU ended up with was an awful German designed compromise: joint bank supervision and a joint resolution regime, but no deposit insurance and no government backstop to bail out failing lenders.
It is no coincidence that bank share prices collapsed just as the European Bank Recovery and Resolution Directive entered into full force. The directive sets out a common bail-in mechanism for a failing bank. Italy applied this law last year in the bailout of four regional banks, causing losses to bondholders. Investors in other banks fear that they, too, may be bailed in. One of the reasons why investors in Deutsche Bank began to panic at the beginning of February was because of the large amount of contingent convertible bonds (cocos) issued by the bank. If the bank were to run into trouble these would convert into equities, and be immediately wiped out if a resolution procedure were to kick in.
The third message is that the markets fear negative interest rates. This is because the vast majority of Europe’s 6,000 banks are old-fashioned savings and loans: they take in deposits and lend them out. The banks would normally adjust the rates they offer to their savers in line with the rates the ECB charges them, maintaining a profit margin between the two. But if the ECB imposes a negative rate on the banks, this no longer works. If the banks imposed negative rates on savings accounts, small savers would take their money and run. The banks could, of course, reduce their reserves at the central bank and lend the money instead. Or they could invest in risky securities. But that prospect is not necessarily reassuring to bank shareholders either, especially if they do not see good lending and investment opportunities.
Looking back, one of the biggest errors committed by the European authorities was the failure in 2008 to clean up their banking system after the collapse of Lehman Brothers. A failure that has profound repercussions today. Many other mistakes subsequently compounded the problem: pro-cyclical fiscal austerity, the ECB’s multiple policy failures and the failure to create a proper banking union.
It is interesting that every single one of these decisions was ultimately the result of pressure brought by German policymakers.
