Understanding the Eurozone
The fundamental macroeconomic policy challenge faced by the Eurozone is how to have a risk free asset – which is essential to the functioning of a modern financial system – while simultaneously preventing fiscal free-riding. Mario Draghi, somewhat miraculously, may have squared this circle. It is worth being explicit about how he has done it, as most of the macro-policy community still seems unaware, and at some point the relevance of this tension is likely to reappear.
The Euro crisis, a run on the sovereign bond markets of member states which started in late 2009 and did not end until ‘whatever it takes’ in 2012, was preventable. If the ECB had engaged in aggressive QE in 2009, like the rest of the world, sovereign runs would never have occurred. At the time, Eurozone QE was not just legally permitted because all member states were freely issuing bonds in public markets, it was arguably a legal obligation. It was clear that deflation was a significant threat, and there was a global consensus that QE was the answer. It is hard not to conclude that the Eurocrisis was primarily an intellectual failure.
Once the sovereign panic had taken hold, and a number of Eurozone sovereigns had effectively lost market access, the legal position of the ECB became compromised. Consider the following dilemma: Let’s imagine that an Italian debt default threatens price stability in the Eurozone, but simultaneously Italy loses market access. What should the ECB do? Its price stability mandate requires that it buy Italian bonds, the legal constraint on it directly funding a member state’s fiscal needs implies it cannot. For these reasons, the legal status of the SMP programme, or the OMT if it ever materialises, look far more questionable than QE would have been in 2009.
Fortunately, there is no reason for the ECB to ever face this mandate conflict, but it reveals a genuine tension. Whatever ones view of the history, there is a contradiction at the heart of Eurozone macro financial policy. A modern financial system requires a risk free asset. To make this clear, consider deposit insurance. Milton Friedman regarded deposit insurance as the most significant US economic policy innovation of the twentieth century. It ended macroeconomically significant deposit runs in America. This is only possible because the money-printing US state ultimately stands behind FDIC, and in extremis, it can honour limitless deposit withdrawals. Because its potential support is unlimited, its guarantee prevents runs. A variant of this exists within financial markets, where treasury bonds act as insurance policies: whenever there is a deflationary panic and risk assets are falling, interest rates fall and government bonds rally. Faced with the threat of recession, the financial system buys government bonds because they have no default risk. The collapsing yield on government securities also creates fiscal space (yes, austerity was a total fraud).
The ability to issue currency – a risk free asset – is therefore the basis of banking stability, the basis of some degree of financial market stability, and the premise of counter-cyclical fiscal support in a modern economy (for more on this, consider emerging markets for contrast).
Europe does not have an equivalent to a treasury bond (it is easily forgotten than German CDS spreads rose dangerously at the peak of the Eurozone crisis: Germany can default in the Eurozone, too). Absent a safety asset, the Eurozone embeds profound economic and financial risk.
One solution to this dilemma would be for the ECB to determine that a default of any member state would threaten price stability. This is certainly plausible for almost any circumstance involving the default of the economies larger than Spain. An Italian sovereign default would result in Euro-wide deflation risk. Implicitly, the ECB – as a matter of law – can never let this happen. The first sign of a significant probability of this occurring and it should intervene to halt the run.
The problem, obviously, is that if the ECB makes this reaction explicit, the market will eliminate credit risk in Italy, and the Italian government will be free to fiscally free-ride. This is the inconsistency at the heart of the Eurozone.
Draghi’s law of conditional safety
Squaring this circle is no easy matter, and committing to doing so may or may not be legal. So how has the maestro of Milan come close to doing so? The ECB, under Draghi’s leadership, has effectively created conditional risk-free assets, which appears not be a contradiction in terms. Simply put, the ECB will stand behind any large sovereign bond market in the Eurozone as long as it is fiscally compliant. This rule has been devised via QE eligibility, which is largely at the discretion of the ECB. The behaviour of sovereign bond markets in the last few years reveal tacit acknowledgement of this rule. Whenever a member state in Europe – be it Portugal, Italy or Spain – announces its plan to take on the Commission and breach fiscal rules, the bond market pounces. QE eligibility is at stake. If you want to issue safe assets in Europe, you have to meet the fiscal rules.
I have broadly described this process before, but it is worth being more explicit. If you support Eurozone fiscal rules, this is huge progress. The bond market is a far more effective law-enforcement agency than the EU, as the recent Italian policy retreat reveals. But is this really a stable or healthy equilibrium?
It may be. Draghi, by virtue of his law of conditional safety, has created the potential for risk free assets in the EZ, although he has not liberated fiscal policy from its dysfunctional straight-jacket. Moreover, logic and incentives now suggest that given member states are bound into the Euro, and the costs are too high for even Greece on the brink of collapse to risk exit, the only way to recover any sort of fiscal sovereignty is to build a fortress around national banks and run with relentlessly tight fiscal policy. The Eurozone savings glut is a permanent feature of this landscape. Will the rest of the world tolerate it?