Europe’s Goldilocks Dilemma

For those of us in the reality-based community who have been calling for an end to Europe’s insistence on fiscal austerity, this month’s meeting of eurozone leaders should have been a cause for celebration: Italian Prime Minister Matteo Renzi finally managed to get Brussels and Berlin to adopt a more "flexible interpretation" of rules regarding budget deficit targets. Finally, it seemed that a change of course had come after six years of disastrous budget cutting.

Not so fast. Europe’s budget-enforcer-in-chief wasn’t going to let that happen. Shortly after Renzi wrenched this concession, Bundesbank President Jens Wiedmann slapped him down, saying that Italy’s insistence on a more flexible budget posed a threat to Europe’s economic recovery.

But most of this is just posturing, anyway. Two much more important factors determine the future of Europe’s budgets. The first is the fiscal straightjacket countries in the eurozone adopted in 2012 via the Treaty on Stability, Coordination and Governance, that reduces the fiscal maneuvering room from "limited" to "don’t even think about it." The second is the ongoing banking crisis that really lies behind Europe’s austere economics. A ministerial summit has little power to change either of them.

The policy of austerity has twin goals: reducing growth in public debt and boosting investor confidence. On both counts, the eurozone’s attempts have been an unmitigated failure.

Debt levels, far from collapsing, have ballooned under austerity, with countries that have cut the most seeing shrinking economies and growing debts. Greece, the poster child for austerity, went from 105 percent of debt to GDP in 2008 to 175 percent today, despite massive bondholder haircuts and a loss of nearly 25 percent of GDP. Over the same period, Portugal doubled its debts from 62 percent to 129 percent; Spain nearly tripled its debts, from 36 percent to 93 percent; and Ireland, hailed as the eurozone’s "success story" for taking the pain and getting back to the markets first, almost quintupled its debt, from 25 percent in 2008 to 123 percent today.

The confidence-inspiring powers of what was curiously called "expansionary fiscal contraction," the idea that budget cuts today make people spend more since they will have lower taxes in the future, haven’t been any better. European consumer confidence dropped precipitously during the crisis and has yet to return to positive territory. Investment expectations, as measured by business confidence surveys, similarly fell as austerity took its toll and are now barely positive. Growth rates track these declines but with a North-South twist: Germany is pulling ahead, France is flat-lining, Italy is stagnating, and the periphery remains in negative territory. Unemployment rates (outside the export-driven North) are stuck at levels last seen on the eve of World War II.

Given all this, you would think a halt to such self-defeating policies would be a good idea. And indeed, it is. But that doesn’t mean that Brussels and Berlin can actually stop austerity.

Few policymakers are willing to admit it, but the heart of Europe’s problems is not excessive government spending or the level of government debt. Instead, politicians focus on these factors since they are easy to blame and allow them to avoid the real issue: the banking crisis. The narrative put forward by the troika of the European Commission, the European Central Bank, and (before they jumped ship last year) the International Monetary Fund — that government spending caused the crisis — is flatly wrong. Eurozone debt-to-GDP was going down in the years before the crisis. The real problem was overlending from Europe’s big banks (going into the crisis) and how the downgrading of Europe’s sovereign debt blew up their highly leveraged model of funding (as the crisis deepened).

European banks got caught short in 2011 when the sovereign debt they used to fund themselves through short-term money markets (where you pledge collateral such as sovereign bonds overnight to borrow for 24 hours and then lend for 30 years) lost value as sovereigns were downgraded. Given that these banks’ balance sheets had grown to be multiples of their underlying sovereign’s GDP, their ability to fund themselves fell apart as liquidity dried up through 2011 and 2012. And since the eurozone is not a country, and yet its members share a currency (and since its biggest member, Germany, was too small to eat all the bad assets involved), there was no way to print the cash to bail out the banks as Washington and London had done.

Having given away their ability to inflate or devalue their way out of trouble, the only policy option left on the table was deflation, accomplished through austerity. But austerity shrinks the economy and makes debts worse, so when bank funding dried up in late 2011, the Eurocrats realized that they needed to fix the banks before the economy could recover.

In December 2011 and March 2012, European Central Bank President Mario Draghi dumped nearly 1 trillion euros of public money into the European banking system in the form of Long-Term Refinancing Operations (LTROs). This, plus his promise to engage in outright bond purchases if needed, have kept European banks afloat. Indeed, as Oliver Wyman, leading consultant to the ECB, noted, such policies kept European banks afloat with "total state support approved for the EU financial sector total[ing] more than €5 trillion, equivalent to 40 percent of [eurozone] GDP."

When all this cash hit the banking system, banks in the periphery decided their best bet was to buy local sovereign bonds. It seemed like an obvious choice: Spanish 10-year bonds offered nearly 7 percent returns in 2012, while the ECB lent at 1 percent. The banks loaded up on these local high-yield bonds and used the profits to bury the huge amount of non-performing loans on their balance sheets. For a while, it seemed like a good idea. 

Unlimited public liquidity worked out well for the eurozone periphery countries. Despite their low growth and austerity-generated high debt levels, periphery 10-year bonds are now trading close to or below their U.S. equivalent. France, for example, which couldn’t hit a deficit target if it were tied to a cow’s backside, today trades nearly a full percentage point below the 10-year U.S. treasury. Investors now know that the ECB will backstop European sovereign bonds and, as a result, yields have fallen as liquidity has been restored. 

But if this is a cure, it’s still a very long road to recovery. Eurozone governors, in particular the ECB, face what might be called a "Goldilocks dilemma." A strong return to growth could paradoxically undermine periphery LTRO-repaired bank balance sheets while too little could leave the eurozone stuck in the doldrums indefinitely.

If policy is loosened and growth accelerates, interest rates will have to rise. If that happens, the periphery banks holding all these now-profitable sovereign bonds will see their asset base shrink as yields go up, bond prices go down, and their balance sheets implode. Given this, the ECB needs super-low rates, more LTROs, and a host of monetary tricks to allow the banks to clean up their balance sheets, one non-performing loan at a time, in an environment of slow growth.

And here’s the rub: If growth is too slow, these policies can’t work. Higher growth rates are needed to allow the banks to repair their balance sheets as new, healthy loans replace the non-performing loans. The ECB’s recent move to negative deposit rates for banks and the new round of targeted LTROs can be seen in this light as a way to boost lending while negotiating this dilemma. But it’s not going to be easy to find a way out.

Given this constraint — where growth can’t be either too hot or too cold — especially when the ECB is doing an Asset Quality Review (AQR) of the banking sector, any loosening up on austerity risks undermining the policies that have brought yields down and re-liquidated the banks. And while the AQR might help clean up of the worst offenders in Europe’s banking sectors, it is hardly a turn against austerity. 

The institutional problem that turbocharges all this is the self-inflected wound called the Treaty on Stability, Coordination and Governance that came into effect in March 2012. This is the eurozone-wide treaty that Renzi wants some slack with — and little wonder. It calls for national budgets to be "balanced or in surplus" in the medium term with enforcement guaranteed by "preferably constitutional" provisions in national legal frameworks. Countries that have "significant observed deviations" from the fiscal limits in the treaty will be fined. This is constraining enough, but what makes it worse is the so-called macroeconomic imbalances procedure (MIP) at the heart of the treaty, which sets the scorecard for how well countries are doing.

The MIP mandates that countries can only have a maximum current account deficit (imports over exports) of 4 percent or a surplus of 6 percent. Given that imports and exports sum to zero, that surplus of 2 percent must be offset somehow. Countries that export a lot, like Germany, could reduce their surpluses, but that’s going to be a tough sell in Berlin. The other option is for deficit countries, such Spain and Portugal, to run permanently tight policies to offset Germany’s surplus. That’s bad news for any attempt to ease up on austerity in the periphery. And while countries must have a (near) balanced budget according to the treaty, they don’t get put on the European Commission’s "time out" until unemployment reaches 10 percent, which, again, suggests that permanently high unemployment will be the price paid for fiscal probity over the long term. It doesn’t look like Greece is catching a break any time soon.

Between the petrified banking system and the procrustean treaty, it is hard to see how the eurozone countries can ease up on austerity even if they wanted to: Low growth isn’t just legally mandated, it’s needed for the banks to crawl their way back to solvency. And given that the surplus countries in the North, not just Germany, are doing just fine with the current setup, it’s not clear why they would really want to ease up anyway.

So two cheers for Renzi’s victory and a more flexible interpretation of the rules. But whether that’s enough to end austerity and heal Europe’s wounds remains very much in doubt.