Europe’s Crash Landing

Originally published at CounterPunch

“Italy is now mathematically beyond the point of no return.”

–Barclays Capital

The situation in Europe gets more depressing by the day. Policymakers have waited too long and now events are beyond their control. The only way to avert a disorderly breakup and another Great Depression is by deploying the European Central Bank (ECB) to backstop the debt of the individual countries, and even that might not work. New ECB chief Mario Draghi must announce his intention to keep interest rates down regardless of the cost. Blanket guarantees are the only way to stop the bleeding. But acting as lender of last resort will not stop the contagion; it will merely minimize the damage. The dissolution of the eurozone is a foregone conclusion. It’s only a matter of time. Here’s an excerpt from an article by Edward Harrison over at Credit Writedowns:

“… it’s game over for the euro zone. The extend and pretend stuff ain’t gonna work…. if you are an investor, this is the moment of truth. Everything – every asset class – depends on how the euro zone performs in the Italian Job. There are only two outcomes, here. If Italy blows up, a Depression is upon us; banks would be insolvent, CDS triggers would implode the system, bank runs would begin, stock markets would crash, and you will would see sovereign debt yields go to unbelievable lows for nations with a lender of last resort.” (“Italy, Italy, Italy”, Edward Harrison, Credit Writedowns)

Yields on Italian debt are soaring while overall economic conditions continue to deteriorate. The eurozone is sliding fast into recession if it isn’t in one already. The EU’s ill-considered austerity measures have increased deflationary pressures and slowed growth. Credit is shrinking while bank balance sheets dip deeper into the red. This is why the ECB intervened in Thursday’s auction of Italian and Spanish debt and loaded up on both hoping to calm the markets and stop the panic. This is from Reuters:

“Traders said the European Central Bank increased its bond buying, but the ECB’s hard-line chief economist told regional governments not to expect the bank to rescue them with unlimited funds.

A sale on Italian debt went smoothly, but worries persisted that Italy’s borrowing costs were unsustainable. The pullback in yields helped support market sentiment.” (Reuters)

Stocks rose on the news that the ECB would announce more bond purchases in a press statement later on Thursday, but expectations are probably too high. Demand has dropped off sharply while the rout continues apace. This is from Der Spiegel:

“Run for your lives” is the new motto in Europe, and not just among banks and insurance companies, which are selling off southern European bonds as quickly as they can, but also among ordinary holders of savings accounts. Banks and regulatory agencies are noticing that anxious citizens throughout Europe are trying to bring their money to safety. The flight of capital from Italy, Spain and Greece is in full swing.

Aside from the ECB, there are no longer many buyers of Italian treasury bonds. It is clear that most investors are trying to reduce their inventories — if they can find someone to take the paper off their hands. It is almost as if buyers were boycotting Italian bonds. (‘Run For Your Lives’; Euro Zone Considers Solution of Last Resort, Der Spiegel)

The ECB has been playing cat-and-mouse with its bond purchases, waiting for the Italian parliament to signal it would pass economic reforms on pensions and labor. These punitive reforms will be pushed through by the man who will likely replace deposed PM Silvio Berlusconi, Mario Monti, who was formerly the European Chairman of the Trilateral Commission and a member of the Bilderberg Group.

Berlusconi’s abdication has had no noticeable effect on the markets nor has the so-called “breakthrough” agreement that was announced more than 2 weeks ago in Brussels. The plan called for the establishment of a $1 trillion eurozone financial emergency fund (EFSF) to address problems that flare up like the Italian bond crisis. As expected, there’s a good deal of disagreement about how the fund should be implemented or from where the resources will come. So far, the only country to purchase bonds from the EFSF has been Japan, and they’ve already lost money on the deal. That’s not an encouraging sign for a fund that is supposed to save the eurozone.

Imagine if Henry Paulson–instead of nationalizing Fannie and Freddie when they were about to blow–had decided to set up a structured investment vehicle funded by issuing bonds to China that would cover 20 per cent first-loss provision on Fannie mortgage-backed securities. Do you think investors still would have held on to their Fannie bonds? No way. There would have been a run on the bank. And yet, this absurd invention is the Eurocrats’ solution to the crisis.

The reason that investors are ditching Italian debt is not because of Italy’s debt-to-GDP ratio (which is currently 120 percent.) No, it’s much simpler than that. Investors purchase government bonds because they believe they are risk-free. Now, however, they’ve discovered that Italian bonds are not risk free, in fact, a default could mean that they would retrieve very little of their original outlay. So, why buy them?

The problem is easy to fix. It’s just a matter of allowing the ECB to act as guarantor of the debt of the individual states. (Which is what the Fed did for the entire financial system after Lehman collapsed.) But the ECB doesn’t want this power because it would preclude the bank from imposing its austerity regime on the member-states while claiming it has no choice to act otherwise. As it stands, the ECB is the perfect tool for spreading neoliberalism throughout the eurozone, and that is precisely what it’s doing.

What’s remarkable about the “debt crisis” is that it was entirely predictable. Many economists warned from the very onset that the monetary union was structurally flawed and wouldn’t work without greater political and fiscal integration. Many critics, like Wynne Godley, focused on the eurozone’s absence of a lender of last resort. Here’s how he summed it up back in 1992:

“If a government does not have its own central bank on which it can draw cheques freely, its expenditures can be financed only by borrowing in the open market in competition with businesses, and this may prove excessively expensive or even impossible, particularly under conditions of extreme emergency….The danger then, is that the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression it is powerless to lift.” (“The Greatest Prediction of the last 20 Years,” Pragmatic Capitalism)

Indeed. Italy and the other countries are in dire straits because they do not control their own currency and, thus, cannot control their own fate. They are entirely at the mercy of the ECB. Is it any wonder why restructuring is never seriously considered (because it would cost the banks and bondholders money) or why there’s been no attempt to create a stimulus program that will lift the struggling states in the south out of their slump and back into the black? The ECB refuses to use the tools that are available to it because its overall policy objectives are already being achieved. Internal devaluation and belt-tightening are the path to privatization, fewer social services, and cheaper labor, exactly what the bankers want.

So, where is all this headed?

I’ll let The Economist have the last word. This is from an article by Ryan Avent in the current issue titled “Finito?”:

“I have been examining and re-examining the situation, trying to find the potential happy ending. It isn’t there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world’s eighth largest economy and third largest bond market. This is triggering margin calls and leading banks to pull credit from the European market. This, in turn, is damaging the European economy, which is already being squeezed by the austerity programmes adopted in every large euro-zone economy. A weakening economy will damage revenues, undermining efforts at fiscal consolidation, further driving away investors and potentially triggering more austerity. The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn’t clear, but it’s unlikely to be pretty.” (“Finito?, The Economist)

The chances of the eurozone surviving in its present form are slim to none.