Whatever it takes

When Ms Lagarde announced that it was not her job to take care of Italy’s budget problems, markets started to “panic”—Italian bond yields “skyrocketed” to an “appalling” 2.5 % nominal.  Suddenly, “Lehman Sister” was no longer showing that much empathy toward other people’s financial problems. But she soon learned her lesson and reverted to the ECB’s official commitment to “whatever it takes” to avoid another Euro sovereign debt crisis.

Draghi’s “whatever it takes” (WIT) monetary stance is now firmly established as the new orthodoxy, thus validating left-wing critics of central banking for whom it was established so as to finance public spending, not to maintain price stability. The ECB is no longer independent, only it has 19 masters instead of one.

We may argue about the merits of WIT monetary policy. Was it so important, after all, to save governments who cannot manage their socialized health care system unless they shut down the entire economy? How is a decade of cheap credit helping you in supplying masks, medicine, and reanimation beds to the patients? How do you like having reassured financial markets and maintained asset prices at their bubble level when you cannot even go the restaurant or get your car repaired? How unfair is it that these nasty Germans who oversaved (thus putting the rest of us in a recession) and harrassed others with outdated budget rules are having an order of magnitude less  deaths than their QE and Eurobonds enthusiastic neighbors? Or maybe there are some dots out there waiting to be connected?

At least Draghi’s response had a clear logic to it. The 2008 recession was an aggregate demand recession. Then the Euro sovereign crisis occurred and there was a bad equilibrium where interest rates on debt were high, leading to fast debt accumulation, a high probability of default, thus validating the high interest rates. This presumption was confirmed by the experience of Spain, which was attacked out of sheer contagion despite a long record of virtuous fiscal policy. In turn, the bad equilibrium, if prevailing, was likely to deepen the recession as the cost of capital would go up and states would have been forced into a brutal fiscal contraction so as to service the debt. WIT, arguably, killed the bad equilibrium, enforcing a good equilibrium with lower interest rates and higher activity.

But we are no longer in 2011. There is no good equilibrium. The analogy is not the Euro sovereign debt crisis but anything in between the first oil shock and the 1923 German hyperinflation (somehow, though, these transfers from Germany to other countries now sound like a great idea), or perhaps the 1793/94 French assignat crisis.

You may pump hundreds of billions of assignats into the Eurozone, your car repair has no use for them if he cannot go to the restaurant and not even buy masks or tests with them. What fraction of that money would have been needed to mass mobilize our “best health care system on Earth” in January?

The French, Italian, and Spanish governments (whose economies only account for some 45% of Euro area GDP) are in a massive shortfall of public receipts. At the same time they are promising  hundreds of billions of “guarantees” to firms that they are coercing in shutting down and to workers whom they are locking home. Unlike the 2011 sovereign crisis where the “Draghi put” did not need to be exercised because the bad equilibrium was killed, these guarantees are going to be claimed.

Not only will people painfully feel their rank in the pecking order for competing for public funds – how much does a small entrepreneur weigh compared to the management of a large government-backed company, an agricultural union, or a neighborhood association who did a great job in helping a mayor’s reelection? – but regardless of how much money they can grab through administrative tricks governments will be compelled to issue hundreds of billions of bonds that can only be bought by the ECB.

The ECB is, in effect, a nonelected transfer agency which moves resources away from the “North” of the euro area to the “South”.

Let’s be optimistic and assume this will look more like 1974 than 1794. If left on their own, the Italians who cannot issue debt any longer and have trouble levying taxes (a very bad idea under those circumstances anyway) would perhaps have a 25 % inflation rate this year, while the Germans who can issue debt would have 5 % inflation. The Lira would depreciate relative to the DM by 20 %. The Italians would pay for their loss of output and budget deficits through the erosion of the real value of their wages and nominal claims. The Germans would have a surge in private savings and maybe borrow on international financial markets (although world interest rates might go up a lot if the world economy is shut down), getting more tax and consumption smoothing than the Italians.

With a common currency, inflation in the Euro area might be say 15 %. German workers, civil servants, small savers, and pensioners will experience a larger reduction in consumption than absent the common currency, and the counterpart to this reduction will be a net flow of goods from Germany to Italy. Perhaps the Germans will sell more goods to China and buy less from them so that the Italians buy more from China. The Italians will suffer less than absent the euro and the Germans will suffer more.

The ECB will say that these inflation rates are optimal given exceptional circumstances and that they will never happen again. But it will continue to have to buy more Italian debt than German debt. And the pensioners, wage earners and civil servants of Europe will realize that billions of euros are easier to print than billions of masks are to produce. They will lobby for indexation mechanisms, which will be granted because the support of these social categories is crucial against “populism”. This will fire up a wage-price spiral, leading to two digit inflation for years. Most importantly, mass unemployment will persist for decades and the cleavage between indexed insiders and non-indexed outsiders who will bear the burden of the inescapable reduction in living standards will be wider than ever. I recommend investing in yellow vests stocks – assuming those plants are allowed to restart.

This is the best case scenario. An important dimension to it is that the transfers from the “North” to the “South” will be permanent. The South will not reduce its budget deficit for many reasons. First, the Union will be in a collective moral hazard situation, of the sort analyzed in the past by people like Tornell and Velasco, by which debts are mutualized but issued unilaterally by sovereign spending units – a tragedy of the commons situation in which fiscal austerity becomes similar to a nonexcludable resource ready to be poached. Second, the Commission and Eurogroup have proved time and again that it will not enforce any fiscal rule as long as there is a good excuse. Third, in the South deficits are determined residually as the unresolved part of a fight between interest groups over public resources. These resources are shrinking. Expect more opacity and more postponement of conflict resolution, i.e. more deficits.

The North can accept becoming the new Lombardy, or the new Catalonia of the Union, while the South will emerge as its new Mezzogiorno. This means having to cope soon with a German Salvini, a Dutch Salvini, an Austrian Salvini, and a Finnish Salvini. Such types are already available on the political catalogue and close to power. Or the North can plan for a smooth orderly dismantling of the common currency, for which plans presumably already exist.

The best case scenario does not look that different from the catastrophic scenario, by which a North country leaves the Euro overnight to preserve its population from the transfer and the inflation, or a South country does it while defaulting on debt and converting private Euro claims into depreciated New Lira or Francs ones at meaningless pre-union exchange rates. It is more a matter of speed than substance.

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