The Euro and Schengen. Common flaws and common solutions

What do the Euro and Schengen have in common? Both are projects that have the same flaw: they're unfinished business. And therefore they risk falling apart. 

The Eurozone is a monetary union, with one currency, the euro circulating in the Union and managed by one central bank, the European Central Bank. What’s wrong with that? One may ask.

The fundamental problem of the Eurozone is that national governments have their own budgets and issue their own debt. When recession strikes, the system gets into trouble. During a recession government budget deficits automatically increase. Countries that are hit hardest by the recession show larger budget deficits and debt increases. Financial markets that are fully integrated in a monetary union are lurking, ready to strike when observing signs of weakness. Countries hit hardest by the recession experience “sudden stop”: investors massively sell the government bonds, raising the interest rates and pushing these countries into illiquidity. The other countries in the system profit from this, as investors in search of a safe haven buy these countries’ government bonds. Thus during recessions, free capital movements destabilize the Eurozone and plunge the weaker countries into a “bad equilibrium” of ever deeper recession and rising unemployment.

What about Schengen? As the Eurozone, it is an unfinished project. The residents of the Schengen Area move freely within the area. The problem is that the architects of that area forgot to integrate the police and the intelligence services. Moreover, they forgot to transfer the authority to control the external borders to one European body.

As a result a problem arises in the Schengen Area that is similar to what happens in the Eurozone. Criminal gangs move freely within the area. They commit burglaries in one country and flee to another one. In contrast police forces have to stop at borders. Terrorists are planning from Brussels how to attack Paris and escape from the radar of the national police forces and intelligence services. National police forces and intelligence services are not integrated and can no longer guarantee the security of their citizens.

The danger of unions that are unfinished is that they will disintegrate. Without a fiscal union free capital movements will create great instability when the next recession strikes the Eurozone. In the long run, governments that can no longer guarantee a minimum of economic stability to their citizens will be tempted to leave the Eurozone.

In the absence of integrated police and intelligence services, nation states in the Schengen zone can no longer take care of the safety of their citizens. They will be tempted to opt out of the zone. In fact this is already happening today.

The choice we have today is simple. If we want to keep the Euro we will have to create a fiscal union. This implies that a significant proportion of national budgets and national government debts will have to be centralized. A formidable transfer of sovereignty from the nation states to European institutions. If we want to preserve the Schengen area, we will have to integrate police forces and intelligence services while creating a joint control at the external borders. Failure to integrate further dooms both projects, the Eurozone and the Schengen area.

The Eurozone and the Schengen area have fundamentally weakened national governments while nothing has been put into place at the European level to offset this loss of power of nation states. The euro and Schengen can only be saved if we create European institutions that can do what national governments no longer can do, i.e. to ensure economic stability and security for the citizens of Europe.

Low oil prices: good and bad news. And how to deal with the bad news.

Since the start of the summer, crude oil prices have started a steep decline again. From more than $60 a barrel in June the crude oil price has dropped to approximately $42. One year ago the crude oil price exceeded $100 a barrel.  These are fantastic price declines rarely seen in the oil market. They have helped the many European Countries to climb out of the recession. This is not surprising. A price decline of this magnitude means that consumers who spend a significant part of their total budget on gasoline now find out that after filling their cars with fuel they have purchasing power left over to buy other things.

Put differently, the oil price decline is equivalent to a reduction in taxes. As a result, disposable income has increased. This effect has been strong enough to more than offset the austerity policies pursued in many European countries. It is responsible for the economic recovery that we have seen in most of Europe. Thus, it appears that the oil price decline is good news.

While the short-term effects of the oil price decline are positive, the long-term effects are not. One year ago crude oil prices stood above $100 a barrel. This created a powerful incentive to develop and expand the use of alternative sources of energy such a solar and wind energy. The latter had become profitable at such high oil prices. Today with low oil prices this may not be the case anymore in many countries.

In addition, low oil prices also have as a pernicious effect of making transportation by car, trucks and planes much cheaper again. As a result, this will give renewed incentives for excessive worldwide specialization intensifying the massive transportation of goods and commodities from one corner of the world to the other. This will increase the emission of CO2 and will further speed up the global warming.

Our conclusion therefore is that if the low oil prices are maintained the long-term effects for the world are very negative. These long-term negative effects most likely outweigh the positive business cycle effects experienced today.

How can this conflict between the short-term positive and long-term negative effects be solved? The economic answer is easy; the political one is difficult.

It would be easy for governments of the oil importing countries to solve this problem by raising taxes on fuel so as to keep gasoline prices at the level existing one year ago and to use the additional tax revenues to lower other taxes, e.g. personal income taxes. As a result, consumers would continue to enjoy a higher purchasing power. This higher purchasing power would not be the result of lower gasoline prices, but of lower income taxes.

Thus, such a tax shift (more fuel taxes and less income taxes) would make it possible to maintain the positive short-term effects on the business cycle, as consumers would have more money to spend. At the same time, because it keeps the fuel prices high for the users, it avoids all the negative long-term consequences of low oil prices for the environment.  Simple, wouldn’t you think? Yes, but unfortunately the politics is more difficult.

The political problem arises from the fact that the higher fuel taxes that the governments have to introduce create many enemies. These are the car companies and the transportation industry. They all profit from the present low oil prices and are likely to resist any tax increase on fuel. In contrast consumers are mostly indifferent whether the increase in purchasing power comes about by lower gasoline prices or by lower income taxes. The net effect is that it will be difficult for governments to overcome the political resistance that will be organized by the car companies and the transportation industry.

The only way out of this political problem is through an opposing political force. Such an opposing force can come about when large segments of the population recognize that low oil prices increase the risk of global warming and that this can be stopped at little cost in terms of economic growth today.  Such a force can twist the arms of the politicians to act and to safeguard the interests of the general population, today and in the future.

The ECB does not learn from its past mistakes

In 2011 at the height of the sovereign debt crisis when investors panicked, the ECB announced its “Securities Markets  Program” (SMP). This aimed at stabilizing the government bond markets. Unfortunately the SMP program was structured in the worst possible way, i.e. the ECB announced it was ready to buy a limited amount of bonds during a limited time. This backfired immediately for obvious reasons. When hearing this announcement panicky investors decided to sell their Greek, Italian, and Portuguese bonds as quickly as possible to be sure they would beat the other investors before the ECB closed the window.  As a result, the ECB had to buy a couple of hundred billion of government bonds without pacifying the markets. The spreads continued to increase.

It took the ECB a year to learn from this mistake. In September 2012 the ECB started with the OMT program. In contrast with the SMP program the ECB promised to buy unlimited amounts of bonds for an indefinite period. The unlimited nature of the commitment made all the difference. Investors were pacified and expected that bond prices would not drop further. As a result, they started buying government bonds of the periphery country. The beauty of the OMT program is that the ECB pacified the market and did not have to buy one euro of government bonds.

Now fast forward to Greece.  The banking crisis in Greece started when the ECB announced that it would cap the amount of liquidity available to the Greek banks. Customers ran to the bank to withdraw cash from their accounts as quickly as possible before the cap became effective. Today (16^th July) the ECB announced that the cap will be increased by €0.9 billion. This will accelerate the desire of the Greek depositors to withdraw cash from the bank, as they know that the available cash is limited. Instead of reducing the banking crisis, the ECB is in fact intensifying it, pretty much like in 2011 when the SMP program intensified the panic sales of government bonds.

The correct announcement of the ECB should be that it will provide all the necessary liquidity to the Greek banks.  Such an announcement will pacify depositors. Knowing that the banks have sufficient cash to pay them out they will stop running to the bank. Like the OMT, such an announcement will stop the banking crisis without the ECB actually having to provide much liquidity to the Greek banks.

These are first principles of how a central bank should deal with a banking crisis. I would be very surprised if the very intelligent men (and one woman) in Frankfurt did not know these first principles. This leads me to conclude that the ECB has other objectives than stabilizing the Greek banking system. These objectives are political. The ECB continues to put pressure on the Greek government to behave well. The price of this behavior by the ECB is paid by millions of Greeks.

Greece is solvent but illiquid. What should the ECB do?

One feature of the Greek sovereign debt crisis, which is widely misunderstood, is the following. Since the start of the crisis the Greek sovereign debt has been subjected to several restructuring efforts. First, there was an explicit restructuring in 2012 forcing private holders of the debt to accept deep haircuts. This explicit restructuring had the effect of lowering the headline Greek sovereign debt by approximately 30% of GDP. Second, there were a series of implicit restructurings involving both a lengthening of the maturities and a lowering of the effective interest rate burden on the Greek sovereign debt. As a result of these implicit restructurings, the average maturity of the Greek sovereign debt is now approximately 16 years, which is considerably longer than the maturities of the government bonds of the other Eurozone countries. These implicit restructurings have also reduced the interest burden on the Greek debt. The effective interest burden of the Greek government has been estimated by Darvas of Bruegel to be a mere 2.6% of GDP. This is significantly lower than the interest burden of countries such as Belgium, Ireland, Italy, Spain and Portugal.

As a result of these implicit restructurings the headline debt burden of 175% of GDP in 2015 vastly overstates the effective debt burden. The latter can be defined as the net present value of the expected future interest disbursements and debt repayments by the Greek government, taking these implicit restructurings into account. Various estimates suggest that this effective debt burden of the Greek government is less than half of the headline debt burden of 175%.

From the preceding it follows that the effective debt burden of the Greek government is lower than the debt burden faced by not only the other periphery countries of the Eurozone but also by countries like Belgium and France. This leads to the conclusion that the Greek government debt is most probably sustainable provided Greece can start growing again (so that the denominator in the debt to GDP ratio can start increasing instead of shrinking as is the case today). Put differently, provided Greece can grow, its government is solvent.

The logic of the previous conclusion is that Greece is solvent but illiquid.  Today Greece has no access to the capital markets except if it is willing to pay prohibitive interest rates that would call into question its solvency. As a result, it cannot rollover its debt despite the fact that the debt is sustainable.

There is something circular here. If Greece is unable to find the liquidity to roll over its debt it will be forced to default. The expectation that this may happen leads to very high interest rates on the outstanding Greek government bonds reflecting the risk of holding these bonds. As a result, the Greek government cannot rollover its debt except at prohibitive interest rates. The expectation that the Greek government will be faced with a liquidity problem is self-fulfilling. The Greek government cannot find the liquidity because markets believe it cannot find liquidity. The Greek government is trapped in a bad equilibrium.

What is the role of the ECB in all this? More particularly, should the OMT-program be used in the case of Greece? The ECB has announced sensibly that OMT-support will only be provided to countries that are solvent but illiquid. But, as I have argued, that is the case today for Greece. So what prevents the ECB from providing liquidity? There is a second condition: OMT support is only granted to countries that have access to capital markets. This second condition does not make sense at all, because it maintains the circularity mentioned earlier. Greece has no access to capital markets (except at prohibitively high interest rates) because the markets expect Greece to experience liquidity problems and thus not to be able to rollover its debt.  

The explicit aim of the OMT-program was to prevent such self-fulfilling expectations that can push countries into a bad equilibrium. It is appropriate to quote Mario Draghi when he announced the OMT-program on 6^th September 2012: “The assessment of the Governing Council is that we are in a situation now where you have large parts of the euro area in what we call a “bad equilibrium”, namely an equilibrium where you may have self-fulfilling expectations that feed upon themselves and generate very adverse scenarios. So, there is a case for intervening, in a sense, to “break” these expectations”[1] Greece today fulfills the conditions for liquidity support as spelled out by Draghi in 2012. Yet Greece is excluded from this support, and as a result it is kept in a bad equilibrium.

The use of OMT to provide liquidity support to Greece is made difficult by the fact that public authorities hold the largest part of the Greek debt. To solve this problem it would be necessary that these public authorities recognize that the market value of their claims on Greece debt is worth a fraction of the nominal value. These public claims could then be sold in the market at a price that comes close to the net present value of the future disbursements (interest plus capital). At that moment the ECB could extend its OMT-promise to these assets (bonds) thereby creating a market for them.

I am aware that this solution creates a political problem. Governments of the creditor countries will have to recognize the losses they have already made on their claims on Greece. Politicians prefer to live in a fictional world allowing them to pretend no losses have been made so that they can hide the truth to their own taxpayers. The solution proposed here forces these governments to come out with the truth, i.e. the losses have already been incurred. I conclude that providing liquidity to Greece is possible provided governments stop hiding the truth.

All this teaches us two lessons. First, the objectives of the creditor nations, including the ECB, that today add tough conditions for their liquidity support is not to make Greece solvent but to punish it for misbehavior. The punishment is deemed to be necessary to avoid moral hazard risk. It is perfectly understandable that creditor nations are concerned about moral hazard. But it is precisely the desire to punish Greece by imposing additional austerity that makes it so difficult for Greece to start growing again and to extricate itself from the bad equilibrium.

A second lesson concerns the credibility of the future use of OMT.  It clearly appears from the Greek experience that the willingness of the ECB to use the OMT program is very circumscribed. It is circumscribed by the ECB’s desire to solve a moral hazard problem. The ECB seems to be saying that OMT will only be used when it can be certain its liquidity support will not trigger misbehavior. And this can only be achieved by imposing tough conditions. Behind the gloves of OMT is hidden a big stick. It is doubtful that future governments that experience payment difficulties will accept to be beaten up first before they can enjoy the OMT liquidity support.

Now that the European Court of Justice has given the legal clearance for OMT, the question arises whether the moral hazard hurdle to the use of the OMT will easily be overcome. I conclude that the credibility of the OMT-program to be used in times of crises is limited.

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[1] http://www.ecb.europa.eu/press/pressconf/2012/html/is120906.en.html

Are creditors pushing Greece deliberately into default?

The Greek drama has entered its endgame. The Greek government has to repay loans to the IMF and other public institutions in the near future but does not have the cash to so. The lenders refuse to come forward in providing liquidity as long as the Greek government does not accept the conditions they impose.

We now hear from the finance ministers that the Greek government is unreasonable because it does not want to accept these conditions. These are that austerity be fully implemented and that the structural reforms that have been agreed to by the previous Greek government, be fully carried out.

But are these conditions reasonable?

The austerity measures that were imposed since 2011 led to devastating effects on the Greek economy. They drove millions of people into unemployment and poverty, and produced intense political instability that is responsible for the rise of Syriza. Insisting on further austerity does not seem reasonable when the failures of this strategy have become so obvious. The surprising thing is that ministers of finance continue to hold the moral high ground and preach to the Greek that they should be more reasonable. Being reasonable is equated to accepting the conditions of the creditors even if these conditions have failed to produce positive results. It is even more surprising that most of the media have now accepted this story.

Some of the structural reforms the creditors insist on are badly needed. Tax reform that would lead the rich to pay taxes, is one. But surely this is a reform that the Tsipras government, in contrast to the previous government, is willing to introduce. But other structural reforms are patently unreasonable. The privatization program that was agreed with the previous government and that the creditor nations insist should be implemented does not make sense. A country should not be pushed into disposing of its valuable assets in a forced fire sale. This will lead to very low revenues for the Greek government and will mainly profit the buyers, some of which are companies in the creditor nations.

We are now being told that the responsibility for failure rests entirely with the Greek government that remains unreasonable and unreliable. It is exactly the opposite. The intransigence of the lenders and the unreasonable demands they impose on a country are responsible for the drama that unfolds.

There is a big contradiction in this intransigence. As is well known, Greece has profited from debt rescheduling in the recent past. Maturities on the debt were extended and interest rates were lowered. According to the Brussels think tank, Bruegel, the effective Greek public debt represents only about 60% of Greek GDP. This appears to be sustainable, provided the Greek economy can function normally. Put differently, Greece can be said to be solvent but illiquid.

The lenders, however, keep the money tap closed. As a result, financial markets are now speculating that the Greek government will not be able to respect the next repayment deadline and will be forced to go into default. The interest rates on Greek government bonds have shot up to levels that make the debt service unsustainable and that make it impossible for the Greek government to refinance itself in the bond market. Speculation has become self-fulfilling and is driving the Greek government into default. But note that this is the outcome of the decision of the creditors not to provide liquidity to the Greek government. It is precisely because the lenders do not want to provide liquidity that Greece may be forced to default.  It looks like the creditors are pushing Greece deliberately into default.

The ECB is carrying a great responsibility.  By providing liquidity it could unlock the stranglehold the Greek government is kept in. Refusing to provide liquidity would make the ECB the single most important actor responsible for a Greek default and a possible Grexit.