Vox has an excellent article by the LSE's De Grauwe about the austerity measures in the Eurozone periphery that were imposed by policymakers in response to a buyer's strike among sovereign bond investors. As yields soared, particularly in Greece, there was a growing belief that the cause was high levels of public debt and structural inefficiencies, and that to bring yields down it was necessary to slash public borrowing and make structural reforms. There was also concern about the lack of competitiveness of periphery economies and their high unit labour costs: had they had their own currencies, devaluation would have been the corrective for this problem, but because of the Euro this was not possible and the only solution was to force down wages. The measures adopted in a number of countries to reduce public deficits and force down wages caused GDP to collapse across the Eurozone. And they are still causing it. The Eurozone is formally in recession and shows no real sign of recovery despite the upbeat commentary from the Eurogroup. PMI figures today were ugly.
De Grauwe and his colleague show that the soaring yields were not directly to do with economic fundamentals in the periphery countries. They were a market panic. And unfortunately, the panic in the markets infected policy-makers too, who inflicted harsher and harsher austerity measures on the countries concerned in an attempt to break the spiral of rising yields and growing fears of Euro collapse. De Grauwe argues that correct response would have been for the central bank to provide unlimited liquidity - in this case, by buying bonds as required. Now, the ECB did buy bonds to some extent under the securities market programme (SMP). But it was hardly an "unlimited" response: it was small-scale, grudging and constantly attacked by Bundesbank hard men and German politicians angry about bailouts for what they perceived as "profligate" periphery states. No wonder investors didn't believe it. There was constant discussion about the possibility of various countries, not just Greece, leaving the Eurozone: there were theories about downsizing the Eurozone to a convergent core, or splitting it in two: there were fears that it would collapse completely as its predecessor the Exchange Rate Mechanism (ERM) had done. EU politicians reiterated that the Euro would survive, but analysts examining the market were divided. And throughout all this, the ECB did virtually nothing, despite the clear evidence of very tight monetary conditions in the periphery and runs on banks in crisis-hit countries. It stepped in to rescue the banking system when liquidity all but dried up in December 2011, and it bought a few bonds. That's all.
I have argued for a long time now that the problem in the Eurozone is not the fundamentals in the individual countries, it is the design and construction of the Euro. The Euro is a fiat currency disconnected from a sovereign - and that is a very strange beast indeed. To a considerable extent, the European policy makers are making things up as they go along, and therefore making considerable mistakes. Belatedly, they are now trying to fix the errors in the original construction of the Euro - the lack of a common banking system, the lack of coordination of fiscal policy, the inadequacy of the institutions created to manage it. The last of these in my view is particularly critical. The Eurosystem of central banks (ECB and national CBs) together create and manage the Euro, and there are strict limits on what unilateral actions a national CB can take: they can provide the domestic banking system with liquidity provided that the ECB gives permission, but they can't do much more than that. They have no control of interest rates and cannot use unconventional monetary policy tools such as QE. So effectively the countries that use the Euro have no control of monetary policy: their central banks can do little to protect their economies from exogenous shocks, and their governments can't do much either since EU rules prevent them using unconventional measures such as capital controls.
I first became aware of just how vulnerable Eurozone countries are, and how little power national CBs have, in a recent conversation with two Irish central bankers who were worried about the stresses in the UK economy. If the UK went into a tailspin, they could do nothing to prevent the Irish economy going down with it because of its extensive trade links and borrowings, and they know that the ECB would do nothing. There is no institutional device in place for protecting individual parts of the Eurozone from local shocks. In real currency unions such as the United States and the UK, that device is fiscal support*. That is absent in the Eurozone.
The ECB, as the senior bank in the Eurosystem, is responsible for ensuring that the money supply in all parts of the Eurozone is sufficient to meet economic needs. De Grauwe says that it failed to do this. I agree. And it is still failing to do this. Inflation is down to the target 2% and falling, and the entire Eurozone is in recession - but has the ECB done anything to ease monetary conditions? No. It is holding the policy rate at 0.75% and the deposit rate at zero, and appears to have no plans to change this even though the Euro is soaring against other currencies as other central banks do all manner of unconventional things to improve liquidity in their own economies. The ECB simply is not acting as a central bank should.
There has been some discussion of whether the market panic that De Grauwe alludes to was irrational. I don't think it was irrational at all. Investors were given no reason to believe that the ECB would act to prevent Euro collapse in the event of a country leaving, and they had the precedent of the ERM, which collapsed after the exit of the UK in 1992. It is no accident that the countries that experienced the steepest rises in yields (and the sharpest falls after OMT) were those where fundamentals differed the most from Germany: after all, it was economic divergence with Germany that drove the UK out of the ERM. Until OMT, it all looked very much like a repeat performance, with Greece as the focal point instead of the UK.
In my view the reason why the OMT worked is that for the first time investors were given a clear statement that the ECB would not allow the Euro to collapse, even if that meant buying every sovereign bond in Europe. Admittedly even that clear policy statement was criticised by the Bundesbank, which claimed that bond-buying would break the Lisbon treaty preventing monetary financing of governments. But what right does the Bundesbank - a national CB - have to criticise the ECB and threaten it with legal action over what was very clearly MONETARY policy designed to protect the Euro, and therefore well within the ECB's remit? The Bundesbank would prefer a strong Euro and tight monetary policy because of its ridiculous fear of inflation. The Weimar hyperinflation scars run deep. But that doesn't give it the right to dictate policy to the ECB. Anyway, there is ZERO prospect of hyperinflation, or even ordinary inflation, in the Eurozone. The problem in the Eurozone is deflation, not inflation - and that has been the case for the last 5 years. The ECB should be cutting rates and looking at other ways of easing monetary conditions across the Eurozone, particularly in the countries such as Spain and Portugal where GDP is falling disastrously. That it has not done so, and shows no sign of doing so, is a measure of its inadequacy.
This is not a crisis of public profligacy, nor even of a poorly-constructed political experiment, grim though the consequences of that are. It is first and foremost a crisis created and orchestrated by an inept and politically captive central bank. The ECB is a disaster.
* I know there are debates about whether various US states will be allowed to go bankrupt, but we all know they will be bailed out in the end, don't we....a municipal Lehman would be the last thing the US government would want.
Panic-driven austerity in the Eurozone and its implications - Paul De Grauwe and Yuimei Ji
Markit Flash Eurozone PMI - Markit
Draghi's Debt Trap - Coppola Comment
It's the currency, stupid - Coppola Comment
The failure of austerity in Europe - Touchstone Blog