Marshall AUERBACK
We now know that there will be a changing of the guard at the European Central Bank (ECB) in October. The current head of the International Monetary Fund (IMF), Christine Lagarde, will succeed current ECB President Mario Draghi at that time.
A known quantity among the political and investor class of Europe, Lagarde seems like a safe choice: she is a lawyer by training, not an economist. Hence, she is unlikely to usher in any dramatic changes, in contrast to current European Central Bank president Mario Draghi, who significantly expanded the ECB’s remit in the aftermath of his pledge to do “whatever it takes” to save the single currency union (Draghi did this by underwriting the solvency of the Eurozone member states through substantially expanded sovereign bond-buying operations). Instead, Lagarde will likely stick to her brief, as any good lawyer does. There’s no doubt that her years of operating as head of the IMF will also reinforce her inclination not to disrupt the prevailing austerity-based ECB ideology.
Unfortunately, the Eurozone needs something more now, especially given the increasingly frail state of the European economies. The Eurozone still doesn’t have a treasury of its own, and there’s no comprehensively insured banking union. Those limitations are likely to become far more glaring in any larger kind of recession, especially if accompanied by a banking crisis. That is why the mooted candidacy of Jens Weidmann may have been the riskier bet for the top job at the ECB, but ultimately a choice with more political upside. An old-line German central banker might have been able to lay the groundwork for the requisite paradigmatic shift more successfully than a French lawyer, especially now that Germany itself is in the eye of the mounting economic storm.
It’s summertime, but the living is certainly not easy in the Eurozone. The Mediterranean economies—notably Greece and Italy—have never really achieved sustainable growth over the last decade, and to the extent that either country ran deficits, or received bailout assistance, it was largely used to pay off debts to a range of bank creditors, rather than generate higher employment. However, the Eurozone’s weakness is now rapidly spreading to the North, notably in Germany, where the Ifo Institute’s manufacturing business climate index is “in freefall,” reports the Financial Times. The Ifo indicator—a good coincident gauge of overall economic health in the Eurozone’s main manufacturing hub—registered its worst reading in nine years, precipitously declining to minus 4.3 in July vs. a gain of plus 1.3 in June. Furthermore, Germany’s Purchasing Managers Index (PMI) has plunged to the mid-40s over the last few months. Fifty is the demarcation separating expansion from contraction, suggesting an imminent recession.
On top of that, Germany’s leading bank, Deutsche Bank (DB), is steadily being revealed to be the greatest repository of corporate corruption since BCCI. Whether it be money laundering for Russian oligarchs (or, allegedly, the Trump family); involvement in interest rate scams such as LIBOR manipulation; violations of U.S. economic sanctions on Iran, Syria, Libya and Sudan (among others); or the sale of toxic securities in the run-up to the 2008 financial crisis, DB has played a leading role, and is now paying the price. Berlin has repeatedly sought to find a buyer for the bank, but both Commerzbank and UniCredit have had a closer look under the hood and ran for the hills accordingly. The share price performance suggests that Deutsche Bank is an imminent candidate for a bailout, if not outright nationalization.
This comes during a historically unprecedented situation in global bond markets, particularly in the Eurozone where negative yields are now pervasive—in other words, investors are now willing to paycertain governments to safeguard their money, whether this be Germany, Denmark, Switzerland, or the Netherlands. This is a foolhardy risk to incur, given that all Eurozone governments are currency users, not issuers (only the ECB creates euros), and therefore carry the same kind of theoretical solvency risk as, say, an American state or municipality.
As the economist Frances Coppola notes, “Every Danish government bond currently circulating in the market is trading at a negative yield. And the inverted curve tells us that markets are pricing in further interest rate cuts, most likely to hold the ERM II peg when the ECB cuts rates and re-starts QE.” Which means yields can become even more negative. Such is the desperation for perceived “safe assets” that Austria, Belgium and Ireland have all sold 100-year securities (the yield on Austria’s 2117 bond has dropped nearly 100 basis points since it was launched two years ago with what was then considered a derisory 2.1 percent coupon, and recall that Ireland’s banking crisis placed the country close to national insolvency 11 years ago). It’s virtually impossible to make sensible economic forecasts a few months out, let alone a century, so this does suggest a certain kind of collective madness (or desperation) now taking over the bond markets.
All of which tells us that something is indeed rotten in the state of Denmark (and elsewhere), as Lagarde takes over as president of the ECB. The constellation of soft economic data in Europe has investors clamoring for the ECB to act, but negative yields suggest that there is little more that interest rate manipulation can do to generate an economic upturn. Indeed, economists Markus Brunnermeier and Yann Koby have persuasively argued that negative yields represent the juncture “at which accommodative monetary policy ‘reverses’ its effect and becomes contractionary for output.” In other words, monetary policy has reached the point where further attempts to cut rates might actually hinder economic growth, rather than promote it.
As Rob Burnett, a fund manager at Lightman Investment Management, has suggested, “What is required is demand-based stimulus and spending must be directed into the real economy”—in other words, fiscal expansion, which unfortunately is not the purview of the ECB. Furthermore, the central bank’s “quantitative easing” purchases of sovereign bonds have hitherto been conditionally predicated on the national finance ministries’ continuing to practice fiscal austerity, which in turn produces the exact opposite economic outcome that Burnett has proposed. The unfinished architecture of the Eurozone makes this problem particularly awkward, given that there is no “United States of Europe” treasury equivalent—a gaping institutional lacuna in the Maastricht Treaty—which in itself creates unstable dynamics that constrain national policy fiscal space. Politically, the ECB represents the awkward focal point in regard to increasing global market integration on the one hand with growing demands for reclaiming national political sovereignty on the other. Such challenges become more acute in the context of a global economy that, outside of the United States, is teetering toward recession (or worse).
It’s also a terrible environment for banking in particular, especially as any attempts to reduce deposit rates below zero (in effect charging depositors for the privilege of having banks store their money) would almost certainly trigger bank runs. Nor are the banks inclined to generate profits via lending activity when there is a steadily decreasing supply of creditworthy borrowers on the other side.
The other problem also relates to the Eurozone’s faulty half-finished architecture: free intra-Eurozone capital flows are promoted within the Eurozone (via the Trans-European Automated Real-time Gross Settlement Express Transfer system, aka the “TARGET2 system”), despite the absence of a unified supranational banking system or common, Eurozone-wide deposit insurance (such as the American FDIC). This creates ample scope for bank runs from one country to another (as the economist Peter Garber predicted back in 1998), and which were occurring in earnest back in 2012, as investor George Soros observed, and specifically tied to TARGET2.
Across the Eurozone, bank assets generally exceed GDP. They also do in non-Eurozone countries, such as Norway, Switzerland, and the UK. But the difference in the non-Eurozone countries is that they are all sovereign currency issuing countries, which means that all have unlimited capacity to provide deposit insurance in the event of a bank run. Paradoxically, it is precisely because of this unlimited currency issuing power that such bank runs seldom go very far in these countries. The public intuitively understands that the insurance can be made good.
This is why the United Kingdom and Switzerland were able to handle their respective banking crises in 2008 without threatening national insolvency. Retaining sterling as the national currency, the UK had unlimited fiscal capacity to offer credible deposit insurance instantaneously during its crisis. To cite one example, in 2007 a regional bank, Northern Rock, applied to the Bank of England (BOE) for emergency support to help it through a liquidity crisis triggered by the subprime mortgage slump in the U.S. and temporarily incurred substantial deposit runs as a result. The BOE’s prompt actions (made easier by the fact that they did not need to secure the collective approval of 27 other countries, as occurs in the single currency union) put a halt to the withdrawals. Likewise, Switzerland was able to recapitalize its own major banks relatively quickly after the 2008 crisis began in earnest and avoided the prolonged banking crises that characterized the Eurozone countries.
Ireland is a good example of the latter. An economy structurally similar to the UK, Ireland experienced a banking crisis with far more longstanding deleterious effects (including an unemployment rate almost double that of the UK at its peak). The crisis was far more serious than in non-Eurozone countries because the markets intuitively understood that the country did not have the fiscal capacity to adequately safeguard the banks’ deposit base (despite pledges to do so on the part of Dublin’s policymakers).
Within the Eurozone, the Emerald Isle’s problems were by no means unique. As is now well appreciated, all Eurozone member states operate under the same constraints with no national currency. In regard to coping with a potential banking crisis, however, the currency issuer, the ECB, does not have the regulatory or political authority to close a bank, regardless of what country the bank claims as its home (in the same way that, say, the American FDIC can operate to shut down a bank, no matter which state, and credibly restart it quickly, by virtue of the backstop of the U.S. Treasury). So far the member states within the single currency union have managed to dodge this particular bullet, but given the mounting strains now intensifying in the Eurozone, a credible banking union of some sort must ultimately be on the table. Wolfgang Münchau, columnist for the Financial Times, outlined the four key “centralised components” required to make such a union workable and durable: “a resolution and recapitalisation fund; a fund for joint deposit insurance; a central regulator; and a central supervising power.”
Even a central banker as powerful as Mario Draghi has yet been unable to persuade the major Eurozone powers, especially Germany, to accede to such a proposal, which Berlin still regards as a covert means of putting German taxpayers on the hook for billions of euros’ worth of other countries’ banking liabilities. In light of the current travails of Deutsche Bank (and the longstanding financial difficulties of Germany’s regional lenders, the so-called “Landesbanken”), however, attitudes might change in Berlin.
In any case, this represents one of the more formidable challenges Christine Lagarde is likely to face in her new job going forward. Given the existing institutional limitations of a monetary union without a supranational treasury backstop, no Eurozone FDIC can be credibly established absent institutional ties to the ECB. National banking interests cannot interfere with the deposit insurance fund because this would immediately destroy the credibility of the banking union. But absent broad multinational consensus, no such supranational FDIC can come into being.
The glue holding the Eurozone’s institutionally fragile structure together has always been the European Central Bank. As the sole issuer of the euro, the ECB is operationally free to provide as many euros as needed to keep the funding system in place. It cannot go broke. But politically, it is an orphan. The problem is that calls for international cooperation to improve its supranational governance structures to address these cross-country dynamics reinforces the impression of eroding national control, which in turn heightens populist backlash across the continent. Mario Draghi’s monetary gymnastics helped preserve the Eurozone, but the battle is not yet won.
One wonders whether someone with Christine Lagarde’s comparatively limited economic and financial expertise has the ability to confront these challenges with the same aplomb her predecessor. We shall find out soon enough.
