Rites of Passage
The Child of Consensus
Conceived in post WWII politics, and baptized in the
political waters of the 90’s, a new common currency- the euro- assumed its
position on January 1, 1999. Representatives
of the prospective member nations masterfully achieved political consensus
by both the absence of objectionable clauses and the inclusion of national
constraints, as manifested in the Treaty of Maastricht.
During that tumultuous process, with deep pride, the elders grasped
and shielded the credit sensitive heel of the infant euro.
The ‘no bailout’ directive for the new ECB (European Central
Bank) emerged as a pillar of the political imperative to address the
‘moral hazard’ issue that so deeply concerned the political leadership,
and, two years later, that same rhetoric of fiscal responsibility continues
to ring at least as loudly when the merits of the EMU (European Monetary
Union) are proclaimed. Unfortunately,
however well intended as protection from a genetic proclivity toward fiscal
irresponsibility, the naked heel is but a magnet for the financial
market’s arrows of our hero’s mortal demise.
As Apollo’s chariot adeptly carries its conflagration
from east to west, the European Monetary Union carries its members on the
path of economic growth. Unlike
the path of the sun, however, the path of an economy continuously
vacillates, including occasional dips into negative territory.
And, like the sign most rental car agencies post by the entrance for
returning cars about to drive over a one way bump strip, the new EMU, with
its lurking unidirectional bias, could do a service to it members with a
similar posting - WARNING- DO NOT BACK UP!
The Dynamics of the Instability
The euro-12 nations once had independent monetary
systems, very much like the US, Canada, and Japan today. Under EMU, however, the national governments are now best
thought of financially as states, provinces, or cities of the new currency
union, much like California, Ontario, and New York City.
The old national central banks are no longer the issuers of their
local currency. In their place,
the EMU has added a new central bank, the ECB, to manage the payments
system, set the overnight lending rate, and intervene in the currency
markets when appropriate. The
EP (European Parliament) has a relatively small budget and limited fiscal
responsibilities. Most of the
governmental functions and responsibilities remain at the national level,
having not been transferred to the new federal level. Two of those responsibilities that will prove most
problematic at the national level are unemployment compensation and bank
deposit insurance. Furthermore,
all previous national financial liabilities remain at the national level and
have been converted to the new euro, with debt to GDP ratios of member
nations as high as 105%, not including substantial and growing unfunded
liabilities. These burdens are
all very much higher than what the credit markets ordinarily allow states,
provinces, or cities to finance.
Since inception a little over two years ago the euro-12
national governments have experienced moderate GDP growth, declining
unemployment, and moderate tax revenue growth.
Fiscal deficits narrowed and all but vanished as tax revenues grew
faster than expenditures, and GDP increased at a faster rate than the
national debts, so that debt to GDP ratios declined somewhat. Under these circumstances investors have continued to support
national funding requirements and there have been no substantive bank
failures. Furthermore, it is
reasonable to assume that as long as this pattern of growth continues
finance will be readily available.
However, should the current world economic slowdown move the euro-12
to negative growth, falling tax revenues, and concerns over the banking
system’s financial health, the euro-12 could be faced with a system wide
liquidity crisis. At the same time, market forces can also be expected to
exacerbate the downward spiral by forcing the national governments to act
procyclically, either by cutting national spending or attempting to increase
revenue.
For clues to the nature and magnitude of the potential
difficulties, one can review the US Savings and Loan crisis of the 80’s,
with the difference being that deposit insurance would have been a state
obligation, rather than a federal responsibility.
For example, one could ask how Texas might have fared when faced with
a bill for some $100 billion to cover bank losses and redeem depositors?
And, once it was revealed that states could lack the borrowing power
for funds to preserve depositors insured accounts, how could any bank have
funded itself? More recently,
if Bank of America’s deposit insurer and lender of last resort were the
State of California rather than the Federal Reserve, could it have funded
itself under the financial cloud of the state’s ongoing power crisis and
credit downgrade? And, if not,
would that have triggered a general liquidity crisis within the US banking
system? Without deposit
insurance and lender of last resort responsibilities the legal obligation of
a non-credit constrained entity, such as the Federal Reserve, is systemic
financial risk not ever present?
The inherent instability can be expressed as a series
of questions:
*Will the euro-12 economy slow sufficiently to
automatically increase national deficits via the reduction of tax revenues
and increased transfer payments?
*Will such a slowdown cause the markets to dictate
terms of credit to the credit sensitive national governments, and force
procyclical responses?
*Will the slowdown lead to local bank failures?
*Will the markets allow national governments with heavy
debt burdens, falling revenues and rising expenses the finance required to
support troubled banks?
*Will depositors lose confidence in the banking system
and test the new euro-12 support mechanism?
*Can the entire payments system avoid a shutdown when
faced with this need to reorganize?
Conclusion
Water freezes at 0 degrees C. But very still water can be cooled well below that and stay
liquid until a catalyst, such as a sudden breeze, causes it to instantly
solidify. Likewise, the
conditions for a national liquidity crisis that will shut down the
euro-12’s monetary system are firmly in place.
All that is required is an economic slowdown that threatens either
tax revenues or the capital of the banking system.
A prosperous financial future belongs to those who
respect the dynamics and are prepared for the day of reckoning.
History and logic dictate that the credit sensitive euro-12 national
governments and banking system will be tested.
The market’s arrows will inflict an initially narrow liquidity
crisis, which will immediately infect and rapidly arrest the entire euro
payments system. Only the
inevitable, currently prohibited, direct intervention of the ECB will be
capable of performing the resurrection, and from the ashes of that fallen
flaming star an immortal sovereign currency will no doubt emerge.
Warren Mosler
May 1, 2001
www.mosler.org