European Central Bank (ECB) Chairman Draghi has a very big agenda. Armed with only a printing press, he's pledging to directly bail out the GIIPS (Greece, Italy, Ireland, Portugal and Spain) and indirectly bail out their economies.
As EU finance ministers meet this week, they would do well to reconsider the feasibility of leaving Draghi to pick up so much of their ball.
Draghi's betting his commitment will give private lenders the confidence needed to invest in the GIPPS. But if not, he say's he can go it alone without causing inflation.
From Draghi's perspective, printing money to buy bonds is simply doing what banks do -- borrow and lend. Each time he prints (electronically creates) new euros and uses them to buy bonds, the new euros show up on the ECB balance sheet as liabilities owed to the public, while the bonds purchased are recorded as assets.
The new euros are, indeed, liabilities. Putting them in circulation either raises prices or keeps prices from falling as fast as they'd otherwise fall. Either way, the public ends up with less purchasing power, and it is this purchasing power that Draghi borrows from the public.
"But," he says. "I'm buying solid assets with these borrowed resources, so the Eurozone public will, through the ECB, own assets worth exactly what it surrenders in purchasing power."
What if Draghi overpays? In this case, he redistributes from the public to those who sold him the bad assets. Since 2008, Draghi has printed over €1.5 trillion euros and bought an almost equal quantity of Eurozone government and bank assets of relatively low quality.
This concern - that Draghi will pay too much for too little and transfer, on an ongoing basis, vast quantities of real resources from the haves (Germany, et. al.) to the have nots (the GIIPS) - is not one Draghi shares. He's pledging to condition loans to sovereigns on IMF-approved fiscal and structural reform and GIIPS acceptance of a new EU banking supervisor to discipline private banks and their non-bank customers.
And if inflation takes off? "No worries," says Super Mario, as he's now being called. "In this case, the ECB will simply sell its solid assets back to the private sector, thereby extracting our euro injections and returning prices to their former levels. Alternatively, we can pay higher rates on reserves and, thereby, keep the injected money in the banks and out of the economy's blood stream."
My preferred nickname for the intrepid chairman is But Mario because his confidence game raises six big buts.
But #1. Draghi's various supplicants have huge holes in their balance sheets, which even the best future behavior and macroeconomic scenario won't close, but which Draghi has signed up to fill. According to the market (not Spanish or other wishful bank regulators), Eurozone banks are, collectively, short €1.8 trillion. Add in likely debt relief of €1 trillion to GIIPS governments and we're talking a year of German GDP. If that's even half right, Draghi has to deliver tons of euros in exchange for, well, nothing. Printing another €1.8 trillion on top of the €1.5 trillion already printed could trigger Germany's 89-year nightmare - hyperinflation.
But #2. Under the ECB's T2 reserve-sharing mechanism, GIIPS central banks have an unlimited line of credit on the Bundesbank and other central banks experiencing capital inflows. Hence, GIIPS central banks can effectively force the Bundesbank, et al. to lend to GIIPS banks, non-banks, and households. They've already forced the Bundesbank to make €750 billion in such loans, with this figure growing €30 billion per month! If the euro breaks up, Germany can kiss this "investment" goodbye.
But #3. Germany retains a veto over the European Stability Mechanism (ESM), and Draghi says he will only purchase sovereign bonds in the context of ESM participation. So Germany can pull the plug on Draghi's confidence game whenever it wants.
But #4. Draghi's muddle-through policy differs little from the past six years of muddle-through that's left the GIIPS with horrendous unemployment, an imminent recession, a massive and accelerating bank run, and tremendous private-sector uncertainty. According to IMF Chief Economist, Olivier Blanchard, muddle-through could take 15 years to work.
But #5. Total GIIPS debt is €3 trillion. And the non-deposit liabilities of the GIIPS banks total $5 trillion. If the private sector doesn't roll over these borrowings, the ECB must. That's a huge amount of euros to print.
But #6. Yes, the ECB has liquid foreign assets that it can sell into the market to suck out new euros it injects into the market. But these assets are limited. They total at most €1.5 trillion at most. Also, paying interest on reserves to keep the banks from lending euros into the markets has its limits. If every euro printed were held in reserves by banks, the banks would no longer be intermediating. They would simply be warehousing the public's money.
Taken together, these buts as well as the opacity of GIIIPS government and bank balance sheets provide plenty private investors plenty of reason to steer clear of the GIIPS, thereby producing not just zombie banks, but also zombie countries. If Super Mario wants to earn his title and really restore confidence, he needs to go beyond "Trust me." to "Watch this." I.e., he has to change the facts on the ground, immediately and permanently.
Doing so requires several things. First, he needs to orchestrate partial, but significant defaults on GIIPS debt that leave the GIIPS fiscally solvent even if their economies take years to recover. Second, he needs to mark all GIIPS banks to market, imposing haircuts on non-depository creditors. These two bold steps will make clear that the investors in risky bonds and risky banks, not the general public, will take the hit for what turned out to be bad investments. It will also verify that fresh euros are not freely available to bad investors with all the long-term inflation risks that entails.
Draghi also needs to move Europe's opaque and extremely leveraged banking system as quickly as possible to a transparent, 100 percent equity-financed mutual fund financial system. The steps here are first swap the remarked bank debt for equity shares in mutual funds while simultaneously selling the remarked bank assets to the mutual funds. Second, require all other financial corporations to operate as 100 percent equity-financed mutual funds. Third, establish an independent agency to verify and disclose all securities bought, sold, and held by the mutual funds, so the world can see precisely what it's buying when it purchases Eurozone mutual fund shares.
This new financial system, called Limited Purpose Banking because it restricts banks to intermediating on a transparent, non-leveraged basis, would end the Eurozone crisis overnight and kick start the GIIPS economies. Indeed, with a banking system that's transparent, has zero leverage, and can never fail and with governments that can pay their bills and that will never have to leave the euro to bail out their banks, Draghi will provide for sure what is now just a pipedream - a real vote of private financial-sector confidence.
Laurence Kotlikoff is an economist at Boston University and author of Jimmy Stewart Is Dead and The Economic Consequences of the Vickers Commission.
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