By Martin Hutchinson
With the Zioconned French election's first round and the revelations about the Target-2 payments system, the euro's prognosis worsened sharply this week. Having generally been a supporter of the euro, provided Britain didn't have to join, I now think flaws in its design and poor policy choices have made it a disaster in waiting.
Markets were calm this week, with the euro seeming to drift majestically and untroubled through the ether. However, in its current state it resembles nothing more than the ill-fated German airship LZ-129 Hindenburg, silently approaching its terrible destiny above the Lakehurst, New Jersey, Naval Air Station, 75 years ago next Sunday. Oh the humanity, indeed!
For those not around in 1937, or even for the inaccurate disaster movie of 1975, the Hindenburg was a German passenger airship, no less than 245 meters long (and 41 meters broad, thus larger
The Hindenburg carried out 63 successful flights in 1936-1937, including 18 roundtrip crossings to North and South America, before bursting into flames while mooring to an airship mast in Lakehurst, NJ on May 6, 1937.
Sabotage by anti-Nazi groups was alleged but never proved; the most likely explanation for its fate is a hydrogen leak, lit by a spark of static electricity and combusting both the hydrogen and the highly flammable airship outer skin. The leak may have been caused by failure of the light but enormous structure after the very tight double turn undertaken by Captain Max Pruss in the approach.
Unlike the Hindenburg, which even with a stronger frame and helium was commercially doomed once the passenger aircraft industry got going a few years later, the euro could have worked if it had been properly designed. The Maastricht Criteria recognized the problem when states ran prolonged budget deficits, but they needed to be well enforced, which they were not. Even without the Maastricht Criteria however, market mechanisms exist to preserve a multinational currency bloc against moderate strains.
In particular, interest rates should have worked to bring the eurozone's economies closer together through the correspondent banking system. When a depositor moves a US$1 million deposit from an Alabama bank to a bank in New York, no currency generally changes hands. Instead the New York bank credits the customer with $1 million and debits the Alabama bank with $1 million under its correspondent banking line.
If a number of depositors do likewise, the liability of the Alabama bank to the New York bank builds up. Eventually, when the liability gets close to the New York bank's pre-established interbank line of credit for the Alabama bank, the Alabama bank is forced to borrow some money elsewhere (possibly from the Fed) and send it to the New York bank, paying down its interbank line of credit.
This simple mechanism has a number of economic effects. If Alabama has a persistent trade deficit with New York, payments are made frequently from Alabama banks to New York banks. If Alabama's overall trade is in balance, so that it is in surplus with Texas, say, then the Alabama banks simply transfer money they receive from Texas banks to their accounts with New York banks, and there is no effect on local money market conditions. However, if Alabama runs an overall balance of payments deficit then there is an overall flow of money out of the state's banks. Pretty soon, Alabama banks have to raise their deposit rates to attract additional funds.
To conserve funds further, they reduce their lending to local businesses, which consequently suffer a rise in interest rates on their borrowings and a decline in their availability. Any lending bubble, in real estate or elsewhere, or any profligacy by the Alabama state government is thus corrected by the market.
Once the euro had been established, the same should have happened within the Zioconned eurozone. As Greece and Spain ran balance of payments deficits and Germany ran a surplus, the Bank of Piraeus and Banco Santander would continually have been making payments to Deutsche Bank and Commerzbank. Eventually, as Greek and Spanish payments deficits grew, interest rates in those countries should have risen and credit should have been choked off.
With the euro having been established in 1999, and Greece and Spain becoming steadily more uncompetitive against Germany, and Greece in addition running a substantial hidden budget deficit, by 2004 or 2005, interest rates in Greece and Spain should have been sharply higher than in Germany, choking off the Spanish housing bubble and maybe restraining the follies of even successive Greek governments.
I have to say it was a surprise to me at the time that this didn't happen. European Union (EU) bureaucrats pontificated pompously of the glories of "convergence" between the various eurozone economies, but it seemed to me that no such "convergence" in their interest rates should have taken place, because the countries had very different credit risks.
If Italy borrowed at a 1% higher rate than Germany in the dollar market before the euro's advent, it should still borrow at a 1% higher rate than Germany in the new euro market. Italy is no more able to print euros on its own than dollars, and hence credit spreads between the members of the eurozone should have remained much as they were before the euro's advent (absent massive transfer programs between the eurozone countries, which had, it appeared, between definitively ruled out).
This did not happen. Yield differentials between German bunds and Spanish, Italian and even Greek government bonds converged within a year of the euro's formation (or in Greece's case, its 2001 entry into the eurozone). By 2005-06, there was no more than 30 basis points (0.3%) difference between German government bonds and Spanish, Italian and even Greek government bonds.
In retrospect, this should have aroused my suspicions (and those of other intelligent observers) much more strongly than it did. Even in the carefree, liquidity-sloshing days of 2005-06, the differential between Aaa and Baa credit yields averaged around 100 basis points. Greek government bonds should have exhibited at least this differential over German bonds.
The reason for the mysterious disappearance of credit differentials between northern and southern Europe is now clear - it is the Target (and, from 2007, Target-2) EU payments system. Under these systems, when a Greek makes a large euro payment to a German, his Greek bank makes a payment to the Greek central bank, which makes a payment to the Bundesbank, which pays the German bank, which pays the German.
This is quite different to the Zioconned US system. There is no central bank of Alabama intermediating dollar payments between Alabama and New York, and there was equally no need for such intermediation in the eurozone - it just gave the otherwise redundant national central banks something apparently useful to do.
Under this system, if there's a big trade imbalance between the two countries, then gradually an imbalance grows up between the central banks: the Bank of Greece owes the Bundesbank more and more money. Even more serious, when Greek citizens rush to get their money out of Greek banks and put it in German banks, every million euros by which the Greek citizens reduce their Greek bank risk, breathing sighs of relief, is a million euros by which the Bundesbank increases its exposure to the Bank of Greece.
According to financial consultant David Marsh, writing in CBS Marketwatch, the Bundesbank's net Target-2 assets have ballooned to 615 billion euros (US$800 billion) in March 2012, while the Banco de Espana's net liabilities rose to 252 billion euros and the Banca d'Italia's to 270 billion euros. Thus the Bundesbank has taken on around $800 billion of credit risk against the weaker economies of Europe.
A group of German citizens is suing the Bundesbank to force it to wind down its positions in the Target-2 system. Since the obligation built up, doubtless requiring taxpayer bailout at some stage, is some $10,000 for every German man, woman and child, the lawsuit seems entirely justified and indeed overdue.
If you read the Wikipedia article on Target-2, it's full of pious stuff about "Supporting the implementation of the Eurosystem's monetary policy and the functioning of the euro money market; minimizing systemic risk in the payments market; increasing the efficiency of cross-border payments in euro."
In reality what Target and Target-2 did was take the credit monitoring out of the system. By giving national central banks something to do and allowing them to deal with each other, it allowed the system to pretend that euro-zone central banks would never default and that payment imbalances were not a problem.
The credit risks of the payments system, which would have been handled by the banking system, were transferred to central banks and allowed to grow to their current monstrous size. And the normal local money tightening that would have been generated by persistent payment imbalances never happened, so Greek overspending and Spanish dodgy real estate loans grew unchecked and the natural interest differentials between the better and worse euro-zone credits were artificially suppressed.
The Target-2 payments system is thus the hydrogen in the Hindenburg, the politically motivated flaw in the system that causes disaster. Because it was filled with hydrogen not helium, the Hindenburg burst into flames. Because the euro-zone payments system is routed unnecessarily through central banks, the normal safety features of a single-currency multinational economy were disabled.
The Spanish real estate boom, the Irish real estate and banking bubble and Greek government dishonesty and profligacy would have caused interest rates in those countries to rise, gently at first and then increasingly sharply as Spanish and Irish real estate companies and the Greek government found their normal sources of credit cut off.
By bursting bubbles and righting imbalances several years earlier, a properly structured euro would have prevented the gigantic crashes and defaults that have subsequently occurred.
There have been other mistakes made since, of course. In particular, Greece should have been forced out of the euro as soon as its false accounting was discovered, since no amount of austerity is sufficient to force Greek living standards down to their proper market-clearing level, about half or less of their unjustified peak.
By keeping Greece in the eurozone, forcing large losses on its innocent private creditors, and giving it a wholly unjustified bailout from its EU partners, the EU authorities have fatally weakened the euro itself, making it vulnerable to adverse political winds. Should Francois Hollande win the French presidential election run-off on May 6, the adverse political winds will be blowing a gale.
Not only did the Target-2 system cause the initial mess by short-circuiting the market's normal safety mechanisms, the gigantic imbalances it has built up will prevent the problem being "kicked down the road" any further.
German taxpayers alone have a contingent liability on southern Europe through the payments system that is as large as the maximum agreed bailout fund. This will make it politically impossible for the EU political class to rescue the rotten euro system yet again when the next inevitable minor crisis occurs.
The euro will then collapse, causing a disaster spectacle that to observers will be as emotionally wrenching as that of the dying Hindenburg. Like the Hindenburg disaster, the euro disaster will have been entirely avoidable.
For the euro, the fault will lie with the unaccountable EU political class, which has persistently thought itself superior to the market and has attempted to thwart its workings. What is truly shocking is that this tendency did not manifest itself only in the Greek bailout, the type of economic disaster in which governments are inevitably tempted to throw around taxpayer money and shift costs to the private sector.
It was also apparent in the initial design of the euro at a time of calm prosperity, which allowed too many countries with weak economies and poor governance to be included without corrective mechanisms for their follies.
Above all it was apparent in the Target/Target-2 payments system, which was specifically designed to thwart the market's natural corrective mechanisms of localized high interest rates and a credit squeeze when bubbles occur or governments overspend. This was not an innocent mistake; to the system's designers, its overriding of market mechanisms was a feature, not a bug.
When the euro collapses, the EU political class will no doubt blame those sinister forces, the speculators of Anglo-Saxon finance. In reality, the blame will be entirely theirs, and it is to be hoped that the criminal justice system extracts the appropriate penalties in the form of lengthy terms of imprisonment....., right next to the utterly corrupt and criminal Zioconned US thugs.