Beneath the Eurozone calm, there is a storm brewing

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BrusselsReport.eu
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Copyright: "Storm Clouds" by Richard Walker Photography is licensed under CC BY 2.0

By Alberto Ruiz-Ojeda, Professor of Public Law at the University of Malaga (UMA) 

Policies intended to support the Eurozone are underpinned by an assumption that politicians will be able to decide in Brussels what they cannot do at home. This is incredibly naïve. Yet, it is what some believe, as they consider the post-Lisbon/post-Brexit European Union to be some kind of “wonderland” unconstrained by the political limits faced by EU Member States.

The stakes are high. The success of the European project has been linked to the performance of the European common currency, the euro. As a result, the Eurozone’s break-up would cause the implosion of the EU. Certainly following the Covid crisis, the Eurozone is on shaky grounds.

In itself, diversity within the Eurozone is not a weakness but a strength. However, the Eurozone’s fiscal asymmetries have contributed to fierce debate on transfers and redistribution, in particular following the Covid-19 pandemic, which saw the emergence of even more extraordinary ECB action and the creation of the 800 billion euro “next generation” EU fund. It is important to address concerns related to this redistribution, given that EU primary law does not permit wealth transfers.

Already before the pandemic, the Eurozone was far from stable

Already before the pandemic, there was a gigantic increase in both government spending and fiscal deficits, all supported by an expansion of the ECB’s balance-sheet, which now covers a large array of securities, both sovereign and private:

It is reasonable to think that this has also strongly distorted both the behaviour of financial market stakeholders’ behaviour and of asset prices.

The ECB’s “quantitative easing” (QE) operations coincide with an increase of Eurozone “M3” during the last seven years. In the Eurozone, “M3” is a calculation of the total amount of euros. According to the ECB’s definition, it includes:

  • the sum of currency in circulation and overnight deposits
  • deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months
  • repurchase agreements, money market fund shares/units and debt securities with a maturity of up to two years

During the pandemic, things took a turn for the worse

Since the pandemic, central banks in major economies have reacted by issuing large amounts of money out of thin air. In unprecedented quantities, money has also been spent by governments in major economies, including in the Eurozone.

Once again, monetary and fiscal authorities have aligned their actions, including revolving doors between politics and central banking. This in contrast to the 1980s, the 1990s and early 2000s, when they acted more independently.

In the Eurozone, this has all happened despite the fact that :

  • Eurozone Member States are not obliged to finance each other, something which EU Treaties forbid
  • There are no mechanisms to impose strict conditionality on net receivers

Hereunder, I’ll take a closer look at the ECB’s actions and its perverse effects, discussing Quantitative easing (QE) programmes, which expand to sovereign and private securities, as well as TARGET2 balances, something which is almost unknown outside the circle of central banking experts.

Quantitative easing

QE is not an unconventional monetary policy tool in the sense that it would be bizarre, original, or sophisticated. Purchasing public debt is very much how central banking started. The Bank of England was incorporated to lend to the Crown the gold necessary for the Napoleonic wars. These loans were securitised in the form of pound sterling notes which circulated as money from that moment on.

The novelty of QE lies in the fact that the Central Bank buys up the assets on secondary markets, so to allow it to influence the market price of these assets during financial turmoil. This still directly affects monetary aggregates, given that when the securities are purchased from non-banks, this increases the deposits sellers hold on their bank accounts.

This money can be utilised to buy goods and services, something which can cause price inflation. Still, during the 2010s, a lot of the extra money remained mostly in the banking system. This because the money injected was meant to bail out commercial banks and states by transferring their financial junk onto the balance sheets of Central Banks, instead of expanding the credit to firms and households.

Things have changed a lot during the pandemic. Monetary injections are being injected into the real economy. Combined with the massive growth in government spending, this directly affects real monetary balances, making inflation plausible.

Last but not least, QE distorts market signals, not only when it comes to the fiscal performance of governments, but also with regards to competitiveness of companies. Given the massive amount of QE, market signals are being eroded and we are witnessing private sector “zombification”.

TARGET2  

 

TARGET2 (Trans-European Automated Real-time Gross Settlement Express Transfer System) is the real-time gross settlement (RTGS) system for the Eurozone. It is a kind of pre-digital-era magic.

The national Central Banks of the Eurozone all have an account at the ECB, to enable an interbank payment system within the Eurozone. Amazingly, however, these balances are never settled.

As a result, we are witnessing Eurozone countries piling up claims and debt against each other, all depending on whether they have incurred current account deficits or surpluses.

To realise how big this problem is, one only need to take a look at the Bundesbank’s Target2 claim on the Banca d’Italia and the Banco de España, which is equal to a whopping 40.99% of the combined 2020 Italian and Spanish GDP.

Conclusion:

If the rules on non-performing loans which the ECB applies to commercial banks were applied to the ECB itself, it would go bankrupt, despite its “phantom concepts” like ‘risk-free assets’, and ‘secure collateral’ or ‘forward guidance on credit standards’.

That is impossible, however, or is it?  In any case, the ECB’s accounts have become the waste-bin for the financial garbage of the entire Eurozone.

In this zero-sum game, there are winners and losers. At the moment, Northern European countries, Germany in particular, are losing.

Looking at the legal structure of the new “Next Generation EU” scheme, in particular Regulation 2021/241, it becomes apparent that the “Eurobonds” that are about to be issued will be ultimately guaranteed by EU Member States, in proportion to the amounts they are about to receive. It is simply puzzling why this won’t be increasing the official debt of these Member States.

A lot of these hard truths underlying the European common currency will need to be faced by Eurozone policy makers at some point.

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