21 January 2015

QE won’t be enough to unfetter Southern Europe


Eight years after the first bank in the eurozone failed and was bailed out by the German government, the eurozone is still in a dreadful mess. Catastrophic policy mistakes have transformed a financial crisis into a much deeper economic and political one. The economy is stagnating: it grew by a mere 0.8% in the year to the third quarter of 2014 and remains 2% smaller than in early 2008. The unemployment rate is a whopping 11.5%. Deflation looms: prices fell by 0.2% in the year to December. A lost decade is not a risk in the eurozone: it is a reality.

With broken banks, crushing debts and a huge shortfall of demand – not to mention poor productivity growth and dismal demography – the eurozone looks set to continue stagnating as it sinks into a deflationary debt trap. Policymakers urgently need to change course: restructure zombie banks, write down unbearable debts both public and private, boost investment and unleash competition and enterprise, with Germany and other surplus countries playing their part.

Yet EU technocrats and establishment politicians across the eurozone dare not stray too far from the line set by the creditor in chief – Chancellor Angela Merkel’s government in Berlin – for which debt restructuring is anathema. So angry voters are turning to radical and extremist alternatives: the radical left in Greece and Spain (and separatists in Catalonia), the far-right in France and Italy, Sinn Fein in Ireland. Depressingly, the only parties demanding the debt restructuring that the eurozone desperately needs are on the radical left. It’s a pity more liberal voices aren’t speaking out too.

Two events this week might shake things up. Markets are pinning their hopes on the European Central Bank (ECB) announcing a programme of quantitative easing (QE) involving large-scale purchases of government bonds at its next meeting tomorrow morning.  On Sunday, Syriza, a radical-left coalition that wants to renegotiate the terms of Greece’s €205 billion loans from eurozone governments, is expected to win the Greek elections. Feverish talk of forcing Greece out of the euro has returned, potentially causing the monetary union to unravel.

The expected ECB announcement tomorrow is unlikely to be a game-changer. Inflation has fallen so far below the ECB’s target of just under 2%, for so long that investors and businesses increasingly expect it to remain there. Once deflationary expectations become entrenched, it is extremely difficult to shift them, as Japan’s experience over the past two decades shows. The ECB would need to credibly commit to do whatever it takes to bring inflation back up to 2%.

Ideally, ECB President Mario Draghi would follow Milton Friedman’s advice and “helicopter drop” cash to eurozone citizens: in effect, print money and send everyone a cheque. At the very least, QE would need to be big and bold – indeed potentially unlimited – with central bankers pledging to buy as many bonds and other assets as necessary to get inflation back up.

But even if he wanted to, Draghi can’t do that, because of political opposition in Germany and legal constraints. Among other things, the Germans fear that if the ECB starts buying lots of Italian government bonds, it will take the pressure off Rome to reform and put its public finances in order. That could eventually put the ECB in an impossible position: keep buying the bonds of a by-then-insolvent Italy or precipitate a default in a €2.1 trillion (£1.6 trillion) bond market – the eurozone’s biggest – that would impose hefty losses on the ECB’s shareholders, not least the German government, and doubtless shatter the euro. Moreover, the German Constitutional Court objects to open-ended ECB commitments that could entail open-ended losses for German taxpayers. So if the ECB does announce a QE programme, it will be limited and hedged with conditions. In other words, it will be too little, too late to avert deflation.

While there is “good deflation” and the bad variety, the eurozone economy is so weak that even the good sort is problematic. Falling prices are generally a good thing if they stem from a positive supply-side shock, like the ongoing collapse in the price of oil, which makes everyone who is a net consumer of oil better off. But in the eurozone’s case, there is a sting in the tail. The economy is so weak that a one-off fall in prices could lead businesses to permanently revise down their future wage offers, entrenching deflation.

In any case, deflationary pressures in the eurozone are mostly of the bad variety – excluding energy, inflation is only 0.6% – a symptom of debt-depressed demand that exacerbates the problem. The prospect of lower prices tomorrow deters companies from investing. And since nominal interest rates can’t go any lower than zero, falling prices push up real borrowing costs, further denting investment while making existing debts harder to bear. That’s disastrous for a Spanish homeowner tied to a big mortgage in negative equity and likewise for governments trying to get a grip on their mountains of debt.

In short, the eurozone seems to face a choice between the politically unacceptable mutual monetisation of its debts and a deflationary debt trap: prolonged stagnation that eventually results in mass defaults. But there is a third option – orderly debt restructuring – which the Greek election might help precipitate.

It is obvious to most people except eurozone policymakers that Greece cannot repay its debts in full. Investors certainly aren’t willing to lend. Since the government was cut off from the markets in 2010, it has relied on funding from eurozone governments and the International Monetary Fund (IMF). Even at the height of the markets’ euphoria about the eurozone last summer, before Germany’s economy stalled, investors desperate for yield and increasingly blind to risk in markets awash with central-bank liquidity were unwilling to lend on terms on which the Greek government could finance itself sustainably – and Greece was soon cut off from markets again.

Public debt now tops 175% of GDP and with the economy gripped by deflation – prices fell by 2.6% in 2014 – the real debt burden is rising. Even under optimistic scenarios for growth and interest rates, bringing it down would require implausibly large payments to hated foreign creditors for the foreseeable future.

A sustained recovery strong enough to make up lost ground, put Greeks back to work, and bring down debt is not in the cards. Having collapsed by more than a quarter since 2008, the economy bounced back by 1.9% in the year to the third quarter of 2014. At that rate, it would recover to its 2008 level only in 2030. One in four Greeks – and one in two young people – remain out of work. Domestic demand is depressed by the debt overhang, while exports remain weak. Even with imports suppressed by crunched incomes, the country is running a whopping (and widening) trade deficit. The banking system is bust. No wonder businesses aren’t investing.

Nor has Greece fixed its fundamental flaws. Despite all the talk of reform, the EU’s priority has been extreme austerity (to get its money back) and wage cuts. The corrupt, clientelist system that doled out government favours and jobs to political patronage networks remains intact. Politically connected businesses continue to have a stranglehold over cartelised markets. The rich still don’t pay their taxes.

Nobody knows how an untested Syriza would behave in government. While its roots are on the hard left, Alexis Tsipras, its 40-year-old leader, has been softening his rhetoric and policy stance. Its spending commitments seem unrealistic. Regrettably, it wants to tax and regulate cosseted capitalists instead of exposing them to competition to up their game. But since it does not have a stake in the clientelist system, it might actually follow through with its reform pledges. And on the key issue of debt relief, Syriza is Greece’s best hope.

If Merkel were wise, she would make a virtue of a necessity and offer Greece debt relief as a gesture of solidarity. She must know that if the euro ultimately collapses, Germany will be blamed – again – for wrecking Europe. The Chancellor could call on historical precedent: West Germany’s debts were halved in 1953 through the London Agreement. She could even throw in a Marshall (or Merkel) Plan of investment for Greece and other crisis-hit countries that would also boost German exports.

Unfortunately, that is highly unlikely. Because of Merkel’s mistaken bailout of Greece’s private creditors in 2010 – notably German and French banks that would have taken losses had an insolvent Greece’s debts been written down – German taxpayers would lose out if Greece’s debt were cut. Since Germans self-servingly believe that as creditors they are virtuous, they feel no obligation to be generous to Greeks whom they view as sinful profligates. And Berlin is loath to set a precedent that could encourage others, notably the Irish, to seek relief for the bank debt unjustly imposed on them by the EU.

So Greece needs to stand up for itself and demand a negotiated write-down, backed by the threat of unilateral default. It can credibly do so: since Athens has a substantial primary surplus – its revenues now cover its outgoings, excluding interest payments – it would not need to borrow if it stopped servicing its debts. Syriza says it won’t write down bonds held by private investors, so Argentina-style legal entanglements aren’t a concern. With the bonds held by Greek banks untouched, the ECB could scarcely refuse to accept them as collateral for liquidity.

German threats to force Greece out of the euro are probably bluster. There is no legal provision for leaving the euro and Merkel certainly has no right to deprive Greeks of the use their own currency. Besides, if Greece were ejected from the euro, it would doubtless default entirely on its €70 billion debts to Germany, so Berlin would be better off negotiating a partial write-down. It is also implausible that unelected central bankers in Frankfurt would dare splinter the eurozone, potentially triggering a domino effect that would leave them without a currency to run. So Tsipras just needs to control his spending urges and stand his ground.

Of course, it could all go horribly wrong. But the alternative is for Greece to remain miserably in the clutches of its EU creditors for the foreseeable future.

Philippe Legrain, who was economic adviser to the President of the European Commission from 2011 to 2014, is a visiting senior fellow at the London School of Economics’ European Institute and the author of European Spring: Why Our Economies and Politics Are in a Mess -- and How to Put Them Right.