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The intervention spiral accelerates


The intervention spiral accelerates

[This article is excerpted from the chapter 11 of the book A Tragédia do Euro. It has been written exclusively for the Brazilian Edition of The Tragedy of the Euro and treats the events from summer 2011 to March 2012]

Purchase of Italian and Spanish bonds

The summer of 2011 was far from quiet. Austerity measures in Italy and Spain were deemed as insufficient by more and more investors. Italian prime minister Silvio Berlusconi was not perceived to do enough while his Spanish counterpart Jóse Luis Zapatero did not address the severe Spanish unemployment. Both had lost their credibility. Zapatero announced early elections for November 20 at the end of July. Nevertheless, market pressure increased and Spanish and Italian bond yields reached new records in the first days of August. The abyss widened and stock markets crashed. As always when politicians needed help, the ECB intervened and started to buy for the first time Spanish and Italian bonds signaling to markets its unwavering support of the political project of the euro.

The bailout by the ECB had two consequences. First, the chief economist of the ECB, German Jürgen Stark, who had protested the purchases but found himself in a minority, declared his leave of the sinking ship of the ECB.

Second, in exchange for the ECB support Spain introduced in the beginning of September a debt limit in its constitution. Yet, the debt limit will be only operative in 2020. The promise for a date when the euro may not even exist anymore, was another attempt to calm markets and, most importantly tax payers in the core of Europe. Merkel could sell the Spanish debt limit as another of her "victories" in order to maintain the illusion that no important losses would arise for German tax payers.

In the mean time the pressure on Berlusconi to follow through on reforms increased. Internal and external pressure made him to resign on November 9 2011. He was followed by "technocrat" Mario Monti, who was welcomed with great hope by markets. Indeed, he enacted some reforms and Italian deficits fell from 2010 at 4.6% to 3.9% in 2011; but the total debt is still at 120% of GDP and rising.

The Spanish elections on November 20 ended with a crushing defeat for the socialist party PSOE. Conservatives under Mariano Rajoy won the absolute majority in the parliament. In a short time, two governments that had been bailed out by the ECB and later replaced.

The reforms of the new Spanish government were not really convincing. While the labour market reform was going into the right direction, it could have been much more ambitious. Rajoy announced also some spending cuts and a recapitalization and restructuring of the banking system financed by tax payers. But he also committed the error to increase taxes which was sold as an "austerity" measure as it has been in other peripheral countries. "Austerity" is a clear misnomer. Higher taxes mean that the government tries to suck more resources into the public sector. The public sector is gaining weight and depressing the space for the private sector. Austerity for the public sector means growth for the private sector and vice versa. Tax increases does not mean austerity of the government.

Spain reached an unemployment record of 4.7 million people in February 2012. At 8.4%, Spain also missed its 6% deficit target for 2011. Once again it was shown that governments do what they want and do not care for reducing deficits as they know that they will be financed by the ECB or bailed out by Brussels. For 2012, the Spanish government expected a 5.8% deficit simply ignoring the 4.4% target that had been negotiated with the Troika in 2011.

Papandreou´s bluff

Not only the Spanish and Italian governments were replaced in 2011. In late October pressures on Greece to deliver on its spending cuts and privatization promises mounted as preparations for a second Greek bailout started. In response to these pressures, Prime Minister Papandreou announced on October 31 a referendum on austerity measures. Most certainly, the Greek population would not have accepted the reforms that the Troika of IMF, ECB and EU Commission demanded in exchange for further bailout money.  Without the bailout money the Greek government would not have had the fund to pay its loans. Thus, Papandreou was implicitly threatening with default implying harsh losses for the European banking system.

His move was a bluff since a default was not in the interest of the Greek ruling class. Without the bailout money the Greek government would have had to reduce its real government spending. Due to the size of the Greek public sector a renunciation of the rescue money was not in the interest (at least short term) of an important part of the Greek population either, since it received a substantial part of its income directly or indirectly from the Greek government.

The bluff was called upon and a few days later Papandreou renounced the referendum and stepped down. His government was followed by a transitional government under the leadership of Lucas Papademos, Ex-Vice-President of the ECB, adviser to Papandreou and member of the trilateral commission.

But Papandreou had achieved his ends by scaring European political and financial elites. The pressure on the Greek government to limit its spending spree was reduced for now. In November 2011 a Greek default could still have produced panic in financial markets. The yields of other sovereign bonds would have increased as the default option became more likely. European banks still needed time to reduce their exposure to Greek debts. While banks kept dumping Greek bonds at the ECB, additional help came from the ECB´s new President Mario Draghi.  

Super Mario and his printing press

Draghi, an ex Goldman Sachs banker had been installed as the President of the ECB on November 1. His rise was accompanied by another change at the ECB. The chief economist of the ECB, the German Jürgen Stark, had stepped down from his position for the similar reasons as Axel Weber. Stark protested especially the purchases of government bonds but found himself in a minority position. Draghi named the Belgian Peter Praet as Stark´s successor. Praet was known as a monetary dove, which is monetary policy jargon for an inflation supporter. Suspiciously, Praet came from a country with a public debt to GDP ratio of around 100 percent. After Italy, the country of the ECB´s President, the next weak country in line was Belgium. It was doubtable that Praet would resist further bond purchases by ECB in the way Stark had done. The ECB was disconnecting itself completely from its Bundesbank legacy.

Draghi´s first action as President of the ECB show how far removed the ECB was from the Bundesbank philosophy. Even though ECB rates were artificially low at 1.5 % and official price inflation rates at 3% - above the upper limit for "price stability" of 2% - Draghi´s first official act on November 3 2011 was not to increase rates to more normal level. Rather, Draghi welcomed the finance industry and governments with two subsequent interest cuts, first to 1.25 % and to 1.00% on December 8 2011. Once again it was shown that the ECB was not independent from politics and concerned for price stability, but rather wanted to save the political project of the euro. When government did not cut their spending sufficiently and got into funding difficulties, the ECB would support them. The ECB was, thus, dependent on government policy.

On 18 of January 2012, the ECB also lowered minimum reserve requirements from 2% to 1%. This freed between €80-100 billion of reserves - a nice kick for cash strapped banks. However, Draghi´s most important move occurred on December 16, when the ECB auctioned off almost €490 billion through the Long Term Refinancing Operation (LTRO). Through the LTRO, banks could borrow for a term of three years reserves from the ECB. They could use the money to prop up their liquidity position as their private financing might not be renewed in the future. They also, encouraged by their governments and by the need to prop up the value of one of their main assets, bought government bonds. Banks could get money from the ECB for three years at 1% and invest in three year Spanish or Italian government bonds yielding around 4%. A nice profit margin of 3% would help them to recapitalize as the ECB and fiscally stronger countries would keep the Eurozone intact.

This unprecedented liquidity injection led yields fall and stock markets increase. The financial system stabilized sufficiently to hold a downgrade of France´s AAA rating by S&P in January 2012.

The first LTRO liquidity injection was followed by a second one on February 29 of €530 billion.  The second LTRO is especially relevant since the ECB watered down its collateral rules in February.[1] National central banks may now determine the eligible collateral themselves. While the Bundesbank objected the change[2], the central banks of France, Austria, Italy, Portugal, Ireland and Cyprus announced to change their collateral rules. In other words: National central banks can produce money to save their banks accepting any kind of collateral such as corporate loans or even mortgages. And there is no limit to it. Even though officially national central banks bear the risk of these operations, the risk ultimately falls back to the ECB and all users of the euro.

When collateral standards, for instance, by the Bank of Italy are reduced sufficiently, corporate loans may be monetized. An Italian company gets a loan from an Italian bank to import German cars. The Italian bank may use this corporate loan to get new reserves from the Bank of Italy. The money supply increases and prices rise. There is a redistribution as the car purchase has been financed by money production. As a consequence target2 debits of the Bank of Italy increase.[3] Thereby, the risk is socialized through the Eurosystem. Unsurprisingly, the money from the second LTRO flew principally into the periphery where banks monetized their bad assets. The ECB is becoming the ultimate bad bank and hedge fund leveraged 36 times (equity ratio of 2.7%).

Fiscal treaties and empty promises

As history had shown, the Stability and Growth Pact was not worth the paper it had been written on. Governments were their own judges and always decided they were innocent. Inspite of numerous infringements, no country ever paid a penalty. On December 9 2011 a EU summit addressed this problem and came out in favor of a fiscal treaty, the European Fiscal Compact, which included harsher sanctions for deficits sinners and the inclusion of debt breaks in national constitutions. Despite its great aspiring, the summit was, however, a loss for defenders of a strong euro.

At this summit Merkel gave up several of her long term demands. First, automatic sanctions for governments that have a deficit higher than 3% of GDP are not included in the Compact. This means that sinners will still judge themselves and most probably never impose a penalty. Also the debt breaks will only become effective in the far future. Even if the euro still exists at this point and nonwithstanding statistical tricks to reduce public debt, most probably politicians will find excuses to circumvent the debt break in the same way they did with the SGP. There is no reason why this should change.

Furthermore, the German demand for an automatic participation of private creditors in future bailouts was given up. Banks can hope to be bailed out by tax payers. Unsurprisingly, bonds of peripheral countries rose in the wake of the summit.

The European Fiscal Compact was signed on March 2nd by all EU countries except the UK and the Czech Republic. Its intention was to calm market and get confidence. Especially, voters in the stronger countries such as Germany were to be lulled in a false sense of security. The idea was to uphold the illusion that Germans and other core citizens would not suffer severe losses through bailouts and that the Euro would be a stable currency. Time was won. The European Fiscal Compact was a marketing coup. In the future, politicians will most likely just ignore the debt limits as "emergencies" appear.


The negotiations for a second Greek bailout had been going on for a while. In the beginning of February 2012 with violent protests on the street of Athens, the Greek government was threatening with default. 

In order to get the bailout money, the Greek government announced a new reform program that involved measures already promised before but never delivered. Indeed, there is no incentive for the government to stick to its promised spending cuts and reforms as it gets the new money anyway.

 In the past years, the Greek government had simply followed its spending spree. Government expenditures 2011 were at €67 billion, and only slightly below the level of 2010 of €73 billion. With public revenues of €47 billion, the 2011 deficit was still at 9.6%. Almost one third of all expenditures must be cut in order to prevent an increase of public debts.

On February 20, an agreement for a second Greek bailout was achieved. It involved pouring €130 billion into the Greek hole. In the following weeks a private sector involvement was "negotiated". Private creditors accepted "voluntarily" a write-off of 53% of their nominal bond value; a 75% real cut including interest rate reductions and longer maturities. Despite of this private sector involvement the Greek public debt to GDP ratio will only falls slightly to 161% after the bailout due to the additional loans to Greece. Nevertheless, the private debt restructuring means a debt reduction of €100 billion, that is €10.000 for every Greek citizen.[4] Such a debt reduction as an reward for the excessive public spending  fosters moral hazard. Why reduce public expenditures when debts are later written off?

According to OpenEurope 57% of the bailout money goes to the Greek government.[5] The rest ends in the pockets of creditors, i.e.the financial industry. Step by step Greek debts are socialized. By 2015, 85% of Greek debt will be held by tax payer backed institutions (ECB, IMF and EU).

capa_Tragedia.jpgThe day of reckoning for Greek debts has only been delayed.[6]  The bailout is kicking the can down the road to maintain the illusion that core tax payers will not suffer losses. Yet, loan guarantees will finally turn into loan losses.

The big loser in this development is Merkel or more precisely German tax payers. The total risks for German tax payers have risen by February 2012 to €2 trillion.[7]  While Merkel knows well to celebrate measures like the European Fiscal Compact or the supposedly harsh pressure on Greece she regains voters support. But the real winners of the winter 2012 are Monti, Draghi, and Sarkozy. With the pressure on Merkel to increase the size of the ESM rising, the transfer union is taking on speed with the new and permanent ESM and the encompassing monetization of bad debts by the ECB. For now, the illusion for currency users and tax payers has maintained: No one appears to suffer losses. However, malinvestments, overconsumption, public spending and bad debts have been and are being financed by money creation. Wealth has been destroyed. Sooner or later, disillusionment will set in, in one form or another. For most people, it will come as a surprise as they realized that their savings have evaporated.

[1] See Chandler, Marc. 2012. ?Reflections on New Collateral Rules."

[2] See Ntv. 2012. ?Weidmann gegen Draghi."

[3] For an explanation of the target2 system see the appendix.

[4] See Sefan Homburg. 2012. "Die bisherigen Kosten der Euro-Rettung eine Zwischenbilanz." In Hauptstadtbrief no. 106, pp. 4-7.

[5] OpenEurope 2012. "The second bailout: bad for Greece, bad for Eurozone taxpayers." Briefing note. March 1st.

[6] It is interesting to note that even if everything goes well in the optimistic plans of the Troika, the Greek debt to GDP ratio will fall to 120.5%! in 2020.

[7] See Sefan Homburg. 2012. "Die bisherigen Kosten der Euro-Rettung eine Zwischenbilanz." In Hauptstadtbrief no. 106, pp. 4-7.

Sobre o autor

Philipp Bagus

Philipp Bagus é professor adjunto da Universidad Rey Juan Carlos, em Madri. é o autor do livro A TragÉdia do Euro.

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