The smell of napalm in the morning

For a while now, I have been nursing the idea that the panic-triggering event in the Euro crisis would be a failed Italian auction. And then I woke up this morning and saw this.

Germany.

The ITAGER and FRAGER spreads are falling because the contagion has reached the inner sanctum.

Excuse me while I follow Krugman and post a music video to go with this.

"Where is the implementation?"

A couple of weeks ago I wrote a post about the first press conference of Mr. Mario Draghi as president of the ECB and I entitled it "A tranquil messenger of continuity". The word "continuity" reappeared yesterday in the title of Mr. Draghi's introductory remarks at the 21st Frankfurt European Banking Congress.

In his remarks, he did not deviate a millimeter from his initial message. The ECB is aware of the current stress in the funding markets, in essence he says, but it is doing what it legally can. Draghi will not risk losing the credibility of the ECB by embarking on stealth fiscal policy. Read below the key passage, implicitly directed to those who demand from the ECB a full scale monetization of the sovereign debt of Italy and Spain:

Let me use this occasion to dwell a bit further on monetary policy in the current environment. Three principles are of the essence: continuity, consistency and credibility.

Continuity first and foremost refers to our primary objective of maintaining price stability over the medium term.

Consistency means to act in line with our primary objective and with our strategy both in time and over time.

Credibility implies that our monetary policy is successful in anchoring inflation expectations over the medium and longer term. This is the major contribution we can make in support of sustainable growth, employment creation and financial stability. And we are making this contribution in full independence.

 

Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs.

These three principles – continuity, consistency and credibility – are at the root of the Governing Council’s outstanding record during the past 13 years in terms of price stability and anchoring inflation expectations. 

What is most relevant to the current crisis: "anchoring inflations expectations is the major contribution the ECB can make in support of financial stability." Those who expect and demand more, will be disapointed.

You can almost sense a heroic stance in his thinking. It is a virtue to resist the calls for unlimited and aggressive financing of European governments, because he is defending a hard-won asset: the credibility of the Central Bank. For this man, it will be a deep personal failure to give in in this issue. My guess is that he would step down first from the presidency. From his point of view, he is doing his part while others aren't:

We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?

UPDATE: Krugman has read the same speech and, predictably, is furious. He cannot understand why the ECB refuses itself from the role of lender of last resort in face of a self-fulfilling crisis of confidence in the Eurosystem. I believe this criticism would be fair if directed to a national central bank. The ECB, on the other hand, is only a piece in game between different nation-states.

Quo vadis Europa?

This question was asked by Joschka Fischer, German Foreign Minister between 1998 and 2005, in a famous speech at the Humboldt University in Berlin, on 12 May 2000. It is entitled "From Confederacy to Federation - Thoughts on the finality of European integration" and you can find it in this document, page 19 (PDF).

The speech is illuminating and should be on the reading list of any student of the current Euro crisis. Take a look, for instance, on this prophetic passage (my emphasis):

In Maastricht, one of the three essential sovereign rights of the modern nation-state—currency, internal security and external security—was, for the first time, transferred to the sole responsibility of a European institution. The introduction of the euro was not only the crowning-point of economic integration, it was also a profoundly political act, because a currency is not just another economic factor but also symbolises the power of the sovereign who guarantees it. A tension has emerged between the communitarisation of economy and currency on the one hand, and the lack of political and democratic structures on the other, a tension which might lead to crises within the EU if we do not take productive steps to make good the short fall in political integration and democracy, thus completing the process of integration.

He was discussing the process of reform upon which the EU embarked as a response to the collapse of the Soviet Union. He then states that Europe was organizing two major projects in parallel: (i) enlargement as quickly as possible (for fear of the orphan republics of the Soviet Union) and (ii) Europe's capacity to act (i.e., the decision making processes). Concerning the drive to enlarge the EU, the German minister had this too say:

Enlargement is a supreme national interest, especially for Germany. It will be possible to lastingly overcome the risks and temptations objectively inherent in Germany’s dimensions and central situation through the enlargement and simultaneous deepening of the EU.

Which are these "temptations"? The drive towards nationalism and militarization, which has always been Germany's natural response to being geographically encircled by potentially hostile nations. But fast enlargement had other benefits:

Moreover, enlargement—consider the EU’s enlargement to the south—is a pan-European programme for growth. Enlargement will bring tremendous benefits for German companies and for employment. Germany must, therefore, continue its advocacy of rapid eastern enlargement.

On the other hand, enlargement without reform of the decision making machinery was dangerous:

 The danger will then be that enlargement to include twenty seven or thirty members will hopelessly overload the EU’s ability to absorb, with its old institutions and mechanisms, even with increased use of majority decisions, and that it could lead to severe crises.

In the second half of his speech, Fischer defends his conception of the final form European integration. I will comment on this section in a future post. Right now, I would like to paste here another quote:

This new principle of the European system of states, which could almost be called revolutionary, emanated from France and her two great statesmen Robert Schuman and Jean Monnet. Every stage of its gradual realisation, from the establishment of the European Coal and Steel Community to the creation of the single market and the introduction of the single currency, depended essentially on the alliance of Franco-German interests.

I read in this an admission that the survival of the eurozone and, perhaps, of the EU itself rest on Germany and France having aligned interests. If this is true, what then does the following graph say to us?

The constrained Queen

The ECB is like a Queen on a chessboard constrained by other pieces of the same color. It is the most powerful piece in the game, but under its rules it cannot move and it cannot take. It is unfair of critics to demand from it the kind of unbridled emergency support a central bank can and should offer inside a true political union. There must be political cohesion backing the radical independence of such a central bank, otherwise its management will be challenged by the legislators.

In this regard, there are three key moments in Mr. Mario Draghi's first press conference as president of the ECB, last thursday (video here). First, at 24'22", answering a question by an Italian journalist on the current rates of the Italian bonds:

"The first and foremost responsibility with maintaining financial stability and orderly financial conditions lies with national economic policies. So it's really in a sense pointless to think that sovereign bond rates could be stably brought down for a protacted period of time by outer external interventions. The main pillar of this is the national economic policy response, and this is made up by two components. First, order, put your public finances in order; second, undertake structural reforms, so that competitiveness is enhanced and thereby growth and job creation."

Then, at 26'31", to a British journalist, about being ready to assume the role of lender of last resort in order to avoid a breakup of the Eurozone:

"What makes you think that to become the lender of last resort for governments is actually the thing that you need to keep the Eurozone together? (...) No, I don't think that is really in the remit of the ECB. The remit of the ECB is maintaining price stability in the medium term."

And finally, at  36'46", to a French journalist, about buying government bonds:

"[The financial crisis of 2008/09] increased risk aversion by all by the investors worldwide. And made their analysis I would say more perceptive of the different risks in different countries and that is how the explosion of sovereign spreads started. Now, as we had what the economists call the undershooting for a long period of time, we may now have overshooting. But the way to react to this is not so much to count on external help. That could alleviate the temporary market pressures, but it is actually the real answer to count on the countries capacity to reform themselves with the right economic policies."

Does that sound like a man ready to dump his mandate and buy tens of billions of euros in Buoni del Tesoro Polianuali in a matter of days, in order to stem the coming panic in the bond markets? Maybe when the Italian 10 year yields approach Irish levels (before Christmas?). Then we may see the Queen turn into a Knight. But he will have to answer to the German King.

Maximum likelihood scenario

In his latest VOX commentary, Charles Wyplosz lucidly maps the way ahead as I see it: a disorderly Greek default, a banking crisis and contagion. This is the key passage:

The political situation in Greece is murky so detailed predictions are implausible. Some basic principles, however, are likely to prevail, as indeed they have done over the last two years.

• It is likely that Greece will be cut out from external funding, so it will default.
• The long feared but unavoidable involuntary and disorderly default will prompt a banking crisis, certainly in Greece but possibly elsewhere as the collapse of MF Global suggests.
• Contagion will soon follow.

Will it be Portugal? Will it be Italy? Probably both will go the IMF and greet the Troika in their respective capitals. More banks will fail in Europe and elsewhere. At that stage, France will come to the front line. This will be a repeat, of worse, of what followed Lehman Brothers, but unlike the Lehman’s debacle, this outcome was clear from the start. Any clearheaded scholar of debt crises could see how this would end. The writing was on the wall all along.
The bright spot is that such a crash may bring us closer to the beginning of the end of the crisis.

I do not agree with him, however, in his assessment of the way the ECB will interrupt the downward spiral:

An ECB backstop does not mean underwriting banks and sovereigns. The ECB guarantee should be partial to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates.

• Banks will have to be bailed out, possibly with EFSF resources, but in the Bagehot way that minimises moral hazard and maximises taxpayer protection.
• That means wiping out shareholders and, if need be, unsecured bondholders.

This is what Sweden did in the early 1990s; it even hired foreign managers – foreign to the web of cross-interests that link bankers and politicians – to quickly return the nationalized banks to profitability and thus protect the taxpayers.

Personally, it seems naive to think that the financial elites in Europe will be "wiped out" by the ECB when it bails out the European banks following the contagion. Is this what happened in the USA in 2008/2009? I simply do not see a Swedish solution as possible in Europe as a whole. The financial elite is just too old and too strong. Europe invented modern banking.

He also seems to miss the fundamental flaw of the Eurozone:

Then, when the crisis is over, the time will come to fix the Eurozone flaws. This means imposing fiscal self-discipline and getting serious about bank regulation.

The flaw of the Eurozone is its lack of a fiscal union, not fiscal self-discipline. And fiscal union is only viable under political union. For literally thousands of years Europe has tried to politically unify herself, without success. That's what makes her the most culturally rich continent in the world. And that is what makes monetary union an impossible project.

Not the gods themselves oppose necessity

My interpretation of Papandreou's play this week. He has envisioned the Greek endgame by now. The austerity programme will drive his country to civil rupture. It may be already driving. The European Union has made it clear that it will not give up procyclical policies as a precondition for financing (see article 7 of the Euro Summit Statement). Whoever has full paternity of the programme under the eyes of hoi polloi will fall and will be under personal risk. Look around the Mediterranean today and behold the fate of unpopular politicians. The logic play for Papandreou is to share as far as he can the paternity of the laws the programme demands. Either a referendum or a coalition government will serve for that. If he cannot share the responsibility for what the Union demands, it is best for him to be ousted now and he knows that. Every move by Papandreou since the summit last week is logical, under the assumption that he has understood the civil order in Greece is going to fall soon.

A tranquil messenger of continuity

From all corners of the Internet, the deflationistas have been calling on the new president of the European Central Bank to save the day buying European sovereign debt on a large scale. For example, here is Paul Krugman last week on this. In his first press conference today, however, Mr. Mario Draghi was a tranquil messenger of continuity and respect for treaties and regulations. He seemed like a man who will need to see people running to the nuclear shelters before he is ready to tear article 21.1 of the Statute of the Eurosystem and the ECB, which reads:

21.1. In accordance with Article 123 of the Treaty on the Functioning of the European Union, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

The invention of universal money

Through Charles Kindleberger, in his Financial History of Western Europe (chap. 4), I learned that Bernardo Davanzati coined (no pun intended) the expression "universal money" in his Lezione delle monete (1588). It is a fascinating read in light of the current events in Europe. There is an old English translation here.

This passage contains the basic principles of expansionary monetary policy as we understand it today; and the "convulsions" and "distempers" remind us of Occupy Wall Street:

Some grave and famous Authors have call'd Money the Sinews of War and Government; but, in my Opinion, it may be more properly stil'd the Second Blood thereof. for as Blood, which is the Juice and Substance of Meat in the natural Body, does, by circulating out of the greater into the lesser Vessels, moisten all the Flesh, which drinks it up as parch'd Ground soaks Rain Water; so it nourishes and restores as much of it as was dri'd up and evaporated by the natural Heat: In like manner, Money, which we said before was the best Juice and Substance of the Earth, does, by circulating out of the richer Purses into the poorer, furnish all the Nation, being laid out upon those things whereof there is a continual Consumption for the Necessities of Life. From the poorer it returns again into the richer Purses; and thus circulating without Intermission, it preserves alive the Civil Body of the Common-wealth. Hence it may be easily conceiv'd that every State must have a quantity of Money, as every Body a quantity of Blood to circulate therein. But as the Blood stopping in the Head or the larger Vessels puts the Body naturally into a Consumption, Dropsy, or Apoplexy, etc. so should all the Money be only in a few Hands, as in those of the rich for Example, the State falls unavoidably into Convulsions, and other dangerous Distempers. Thus it was very near happening at Rome, when by reason of the multitude of accus'd Persons, of Condemnations, Slaughters, and Confiscations, all the Money was like to come into the Exchequer, had not Tiberius distributed two Millions and a half of Gold into the Banks, when it was to be lent to Debtors upon double Security for three Years, without any Expence or Interest.