Last week was a highly significant one for the EU and the eurozone, but not in the way you might think. Mario Draghi, president of the European Central Bank (ECB), has driven a coach-and-horses through the teutonic barricades of the monetary orthodoxy. While it’s interesting to witness a German defeat for the first time in this crisis, the really interesting aspect is the process that Draghi has unleashed – and where it will end.
The announcement that the ECB will buy the bonds of Spain and Italy will not be enough to stop this crisis, but it has paved the way for the next initiative, which will be evident as soon as the euphoria of this new move wears off. The next big thing will be a fiscal expansion, not contraction, in Europe. Yes, you read right, expansion.
I realise, at this stage, that this is anathema to everything that has gone before – and it is. But so is the idea that the ECB could monetise debt – which is exactly what it has just announced. We are in a state of flux and strange things are happening. Old positions are being abandoned and, in the course of doing ‘whatever it takes’, the world, as we know it, is changing dramatically. So keep an open mind.
In order to get our heads around this change, let’s first define the problems in Europe. Europe has a growth crisis, not a debt crisis. There is a debt crisis because there is a growth crisis, not the other way around. Hoping that austerity would deliver growth in an already enfeebled economy is akin to putting an anorexic girl on a diet and hoping that she will put on weight.
More childishly, thinking that the ECB buying bonds while continuing with austerity is a permanent solution is like putting the same anorexic on a drip and announcing her return to full health.
In time, we will see this for what it is – a short-term palliative designed to satisfy the bond vigilantes who have been threatening Spain. It will buy a bit of time. That’s about it. And each bailout or ECB move has seen more and more money buying less and less time.
That said, those of us who warned that the euro was a problematic currency many years ago (rather than the recent converts, wide-eyed with new-found scepticism) knew that the central bank had to, at the very least, open up its balance sheet to buy the bonds of countries in trouble if the currency was to have any chance of surviving.
Now that we have begun to monetise debt in a move that the head of the Bundesbank, Jens Weidmann, last Friday considered was “too close to financing states via the printing press”, where will this stop?
Someone should spell things out to Weidmann. This is not “close to” the printing press, it is the printing press in the old-fashioned Argentinean sense of the word. We are seeing the ‘lira-isation’ of the euro and, before it’s all over, we will also see countries dropping the IMF conditionality guidelines and borrowing lock, stock and barrel; financed by the ECB.
This will happen because growth will not rebound and, without growth, all plans falls apart.
Think of the move last Thursday as part of a continuum. The old euro settlement is coming apart at the seams.
The volte face by the ECB, which is now buying government bonds directly, is the beginning of the end for the policy orthodoxy that has dominated thinking at the top of the ECB, the EU and various departments of finance around the eurozone for years. In time, the unorthodox monetary policy announced by Mario Draghi last week will be followed by heterodox fiscal policies.
Europe will see a massive fiscal expansion in the years ahead, and this fiscal expansion will kickstart the moribund eurozone economy.
There is nothing new in this conclusion. This is what happened in the 1930s, it is what happened in Japan in the 1990s and 2000s and it is what is happening now in the US.
Before you point out that Japan has been growing very slowly since 1991, just think what domestic demand would have been like there had the government not spent.
The same policy is likely to happen in Europe because this is what has to transpire for the euro to survive. As all the elites are in support of the euro more than they are of any other policy, the price of a credible currency is growth and it will come with expansionary, not contractionary, fiscal policy.
The reason is straightforward: Europe’s banks are broken and much of the continent is entering a liquidity trap. Monetary policy isn’t working, so the authorities will have to try something else.
Demand can come either from the continent itself or from exports. But exports, particularly industrial exports to China, will slump as China suffers from the mother of all property crashes in the next three years. In fact, the coming Chinese property crash will make even ours look modest. The US, although set to be the pre-eminent economy in the world again over the next decade, will take time to get there.
Against this background, domestic demand will have to drag Europe up. This domestic demand will come from budget deficits. Don’t let anyone tell you that the markets won’t finance a fiscal expansion in Europe – they will be gasping for it soon and at rates of interest that will be historically low initially. The threat is deflation; the solution is inflation. It has ever been thus but it, too, will take time.
The reason peripheral Europe can’t get financed is that fund managers on the periphery are putting their money in core bond markets. Look at the countries with their own exchange rates – Britain, the US, Japan, Denmark, Sweden and so on. They are having no difficulty getting finance.
Once the ECB is in buying, it backstops risk and it won’t be able to stop, irrespective of all the wittering on about conditionality. The notion that finger-wagging will stop governments borrowing is embarrassing. By opening up the balance sheet, the ECB has given Europe the permission to borrow. After all, common sense says that you discipline a borrower by cutting off funding, not opening up your balance sheet in unlimited quantities.
All this is still a little bit away yet, and the idea of fiscal expansion will be dismissed as bizarre by those same people who told you a few years ago that there was no problem with the euro. We now know that the biggest threat to European rules – and German rules in particular – is the euro.
Expect lots of euphoria for now – until it dawns on the insiders in Europe and at our Department of Finance that an anorexic on a drip isn’t a healthy patient.