This crisis is likely to culminate with capital controls re-imposed in Ireland, following a Europe-wide run on the banks. This bank run will be an accelerated and panicked version of what is already happening right now. Money is likely to leave all the major banks of the eurozone with the exception of German banks.
This is because savers fear the breakup of the euro will leave them with “cheapened” savings in their own countries. Obviously, the corollary of this should be a wall of money flooding into Germany because — whatever happens — the currency that Germany will eventually trade in will rise against all others.
And so we are likely to see a massive credit crunch all over Europe because without funding, lending will dry up.
As lending dries up, growth will plummet and the already fragile bond markets of the non-German members of the eurozone will close down. This means that the enormous redemptions which are necessary next year to roll over the huge national debts of Italy and Spain, together with France will not be financed. These countries will have to renegotiate their debts.
Yesterday, for example, Italy raised money but paid more for three-year money than for 10-year money. The three-year yield was 7.89pc while the 10-year yield was 7.56pc . This is abnormal because you should always pay more for money that you borrow over the longer term, not least because — based on the bird in the hand notion — the risk to the lender rises as the amount of time the lender has to wait to get his money back is extended. But in Italy, the risks are now accumulating in the near term as money leaves the country and the expected crisis comes closer.
The rest of Europe is now imploring the ECB to act and save the day. Who else will buy these bonds if the ECB does not? But it is quite likely that the European Central Bank will sit on its hands, hiding behind its limited mandate, which prevents it from financing governments. Maybe the reason the ECB is not acting is that it has misdiagnosed what is going on.
I speak now as a former central bank economist when I talk about the type of thinking that has taken over in the heads of ECB economists. In the 1990s, there was an obsession with government spending inside the heads of economists at the various European central banks.
This line of thinking saw “evil” governments everywhere and if the central banks financed these free-spending governments, it would lead to fiscal incontinence everywhere.
Possibly as a result of this thinking, the German faction in the ECB believes two evidently false propositions and because it has not diagnosed the problem correctly, it lurches to the wrong conclusion.
The first misdiagnosis is that the eurozone crisis is the result of too much government spending. This is patently not true. Ireland and Spain entered the crisis with budget surpluses and Italy has been running a primary surplus for years. Only Greece fits neatly into the “too much government spending” model. We all know that the main problem is excessive lending by private banks to the private sector.
The second canard held dear by the ECB economists is that austerity leads to growth. This idea is so silly that it is amazing time is still devoted to it. But here goes. Some economists believe that if a government cuts spending, the average citizen will conclude that his taxes in the future will be lower, which makes him feel richer today. As a consequence of this extraordinary insight, he will bring forward spending that he was going to make in two years’ time to today.
Can you think of anything more ludicrous?
This thinking leads to what I would call “policy vindictiveness”. The ECB sees the crisis now as an opportunity to teach governments a lesson and to drive home the point that the ECB has been right all along. Therefore, we get an element of vindictiveness in its overall approach.
But it fails to realise that it is maturity and wisdom and not small mindedness that is called for now. The ECB’s job is not to use the crisis to prove a point but to stop a dire situation becoming worse. However, while rhetoric is cheap, wisdom is — unfortunately — in short supply.
As a result, the central bank does nothing as the commercial banks experience a run on deposits. Bank runs happen quickly; that is why they are called bank runs, rather than bank ambles.
Here in Ireland, as savers’ money floods out of the country, the State will be faced with a choice. Does it allow this to happen or does it impose currency and capital controls to “lock in” money? We will not be the only country faced with this choice — all peripheral eurozone countries will be faced with the same dilemma as the citizens move to protect their savings.
Remember the citizens will be the last to “doubt” the banks. Shareholders have already sold, so too have bondholders, the final sources of bank funds are small deposits and, as always, they are the last to move. The big deposits moved a long time ago as evidenced by Siemens moving â‚¬6bn out of Soc Gen a few weeks back. This is a recurring pattern in financial history — the little guy always pays.
After the imposition of capital controls, the existence of the eurozone will come into question because it is hard to sustain the idea of a monetary union with capital controls. At this point, its strikes me that the most likely next move will be that the core countries, including France, will execute the plan they have been hatching for some time now, which is to move forward with a two-speed euro.
In fact, a move to a two-speed euro can only happen if capital controls are imposed. As these events tend to happen quickly, many citizens will not realise what is happening until it is over and done with.
The whole debate in Ireland about the next phase of the euro is reminiscent of the boom years where those of us who called the boom correctly as nothing more than a “vacuous confidence trick” and a “scam” were labelled unpatriotic, while those who ripped off the people with greed backed up by “quack economics” peddled by fully paid-for “quack economists” were treated as national heroes.
Again the temptation here with the euro will be to shoot the messenger. But that would be wrong.
Europe is headed towards a major policy shift, the most likely outcome is some type of two-speed euro but before that happens, the people will panic. And all the while the ECB, which could do something, does nothing because it wants to prove a point.