Marshall Auerback, who is working for more than 25 years as an investment manager, is serving as a global portfolio strategist for RAB Capital Plc, a UK-based fund management group. He is also co-manager of the RAB Gold Fund and an independent economic consultant for PIMCO, the world’s largest bond fund management group. Further, he is a fellow of the Economists for Peace & Security (www.epsusa.org) and of the Japan Policy Research Institute in California (www.jpri.org). As Braintruster of the Franklin and Eleanor Roosevelt Institute, he is a frequent commentator at “New Deal 2.0” (www.newdeal20.org). In this exclusive interview for MMNews he talks about the euro zone.

Mr. Auerback, you see profound problems coming to the euro zone.

Well, I think the euro zone is a really big problem. I've said this before, but in here it is again:

"Government spending is financed through the issue of currency, taxes generate demand for that currency that results in sales to government, bond sales merely substitute bonds for cash, and central bank operations determine interest rates and defensively add or subtract reserves. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; in this circumstance, taxes really do 'finance' state spending and states really do have to borrow (sell bonds to the markets) in order to spend in excess of tax receipts. Purchasers of state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate. Functionally, each nation state operates the way individual American states do, but with ONLY individual state treasuries."[i]

Consequently, the euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced. Deficit spending in effect requires borrowing in a ‘foreign currency’, according to the dictates of private markets and the nation states are externally constrained. That's why Iceland and Latvia are in a mess and suffer from solvency issues. It's also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan. Greece is simply the soft underbelly of the euro zone.  If Greece goes, they all start to go.

What are your expectations for Greece?

As far as Greece goes, in the first instance, the sanctions available (if any) to punish Greece for spending more than the EU or ECB would like is via the Stability and Growth Pact (SGP), which as you know are imposed as fines by ECOFIN for violations of deficit limits

Operationally, the Greek Treasury writes its checks on Greek banks. When it does so, it creates euro.  

Does any operational constraint limit the capacity of the Greek government to create euro in this way? Or is the only constraint the self-imposed one of the SGP?

Well, for one thing, it has to have euro in its bank account at the Greek bank, unless the Greek bank wants to loan its euro. Perhaps the Greek government spend without going to the bond market, but it can't create currency. It can borrow from the banks, but that 'uses up' bank capital and balance sheet, and adds risk to that bank, etc. 

During a period of euro weakness funding problems could become worse and spread to other euro nations.

When foreign governments buy euros for their portfolio of foreign exchange reserves, they have to hold them in some kind of account or security.  Most probably option for the euro zone is national government paper. Same with international institutional investors. When they stop adding to their euro portfolios and/or reduce them, they stop buying and/or sell that paper.

The new holders of euro (those who buy the euros when portfolios sell them) may or may not buy that same government paper, and the euros may instead wind up as excess reserves at the ECB in a member bank account, or even as cash in circulation as individuals who don't trust the banks turn to actual cash. The banks with the excess reserves may or may not buy the National government paper or even accept it as repo collateral, to keep their risk down, and instead simply hold excess reserves at the ECB.  

Markets will clear via ever widening funding spreads as national government paper competes for euros that are otherwise held as 'cash reserves.'  The amount of reserves held at the ECB doesn't actually change, apart from some going to actual cash.  What changes are the 'indifference levels'-yield spreads-between having cash on your books and holding national government paper risk. And the ability to repo national government paper at the ECB doesn't help much. 

Would you buy Greek paper today if you were concerned it might default just because you could repo it at the ECB, for example?        

Additionally, while Americans go to insured banks and Tsy secs when they get scared, Europeans exit the currency as they have a lot more history of hyper inflation.  

That means a non virtuous cycle can set in with a falling euro making National government funding problematic, which makes the euro continue to fall.   

Didn’t happen this already before? And what is the difference now?

Yes, this happened a little over a year ago due to a dollar funding liquidity squeeze. The Fed bailed them out with unlimited dollar swap lines and the euro bottomed at something less than 130 to the dollar. This time it's not about dollars so the Fed can't help even if it wanted to.

And the 'remedies' of tax hikes and/or spending cuts Greece intends to pursue will only make it all worse, especially if undertaken by the rest of the euro zone as well. Fiscal tightening will only slow the economy and cause national government revenues to fall further, unless the taxes are on those taxpayers who will not reduce their spending (no marginal propensity to spend) and the spending cuts don't reduce the spending of those who were receiving those funds.  And the treaty prevents ECB bailouts of the National governments so any bailout from the ECB would require a unified Fin Min action and an abrupt ideological reversal of the core monetary values of the union towards a central fiscal authority.   

This is somewhat analogous to what happened to the US when the original articles of confederation gave way to the current constitution in the late 1700's.

I have suggested a solution which could work here, but I doubt the ECB will buy it.

Here it is:

DEFICIT TERRORISM COULD KILL THE EURO[ii]

By Marshall Auerback

On more than a few occasions, we have discussed the insanity of self-imposed political constraints which limit the range of fiscal policy. As well as imparting a deflationary bias to an economy (and thereby preventing full employment), these kinds of constraints preclude the adoption of prompt counter-cyclical policy, which would otherwise cushion an economy when confronted with a genuine financial crisis, as we are experiencing today.

The constraints under which the US operates are more apparent than real.  As we have discussed before, these constraints are largely based on 19^th century gold standard concepts, which have no applicability in a fiat currency world. Tomorrow, if the US wanted to run a budget deficit equivalent to 20 per cent of GDP, it could do so, politics and demagoguery aside. 

Such is clearly not the case in the euro zone, where countries, such as Spain, that have 20 per cent unemployment are being forced into further belt tightening. And the news just keeps getting worse: Expansion in Europe’s service and manufacturing industries unexpectedly slowed in January, adding to signs the pace of the economy’s recovery may weaken.

A composite index based on a survey of purchasing managers in both industries in the 16-nation euro region fell to 53.6 from 54.2 in December, London-based Markit Economics said today in an initial estimate. Economists expected an increase to 54.4, according to the median of 15 estimates in a Bloomberg survey. A reading above 50 indicates expansion.

The euro-region economy may lose momentum as the effect of government stimulus measures tapers off and rising unemployment erodes consumers’ willingness to spend. More significantly, the very viability of the currency is now being called into question even within the councils of the European Monetary Union (EMU), where fears of a euro breakup have reached the point where the European Central Bank (ECB) itself feels compelled to issue a legal analysis of what would happen if a country tried to leave monetary union (http://www.telegraph.co.uk ).

A currency vaporizing before our very eyes!  All for what?  Some misguided anti-inflation fear? A desire to maintain the euro as a “store of value”?  What’s the point of having a “store of value” in your pocket when you don’t have enough of it to buy anything because you’re unemployed?

We have long viewed the principles underlying Europe’s monetary union as profoundly misconceived.  In particular, the so-called Stability and Growth Pact is economically flawed and politically illegitimate, given the power of unelected bureaucrats within the euro zone to ride roughshod over the clearly expressed preferences of national electorates.  A law that governs economic decisions yet is economically illiterate cannot stand for long.  It merely invites non-compliance and worse, as we are witnessing today.  And the problem is not restricted to the so-called “PIIGS” countries (Portugal, Ireland, Italy, Greece and Spain).  The larger – and wealthier – European economies however have never reduced their unemployment rates below 6 per cent and the average for the EMU since inception is 8.5 per cent (as at July 2009) and rising since. The average for the EMU nations from July 1990 to December 1998 (earliest MEI data for the EMU block available) was 9.7 per cent but that included the very drawn out 1991 recession. Underemployment throughout the EMU area is also rising (http://bilbo.economicoutlook.net), reaching 20% in Spain and double digits in Portugal, Italy, Ireland, and Greece.

Until now, the Eurocrats have either remained in denial about the mounting stress fractures within the system, or forced weaker countries to impose even greater fiscal austerity on their suffering populations, which has exacerbated the problems further.  And there has been a complete lack of consistency of principle.  When larger countries such as Germany and France routinely violated spending limits a few years ago, this was conveniently ignored (or papered over), in contrast to the vituperative criticism now being hurled at Greece.   The EU’s repeated tendency to make ad hoc improvisations of EMU’s treaty provisions, rather than engaging in the hard job of reforming its flawed arrangements, are a function of a silly ideology which is neither grounded in political reality, nor economic logic.  As a result, a political firestorm, which completely undermines the euro’s credibility, is potentially in the offing.

So what are the alternatives?  Exit from the currency union would be the most logical, but also potentially the most economically and politically disruptive.  As Professor Bill Mitchell notes, to exit the EMU a nation and regain currency sovereignty, the following changes would occur:

• The nation would have to introduce a new/old currency unit under monopoly issue. Within this currency the national government could purchase anything that was for sale in that currency including domestic unemployed labour.
• The central bank of the nation would receive a refund of the capital it contributed to the ECB.
• The central bank would also get all the foreign currency reserves that it moved over into the EMU system.
• The nation’s central bank would then regain control of monetary policy which means it could set the interest rates along the yield curve and also add to bank reserves if needed.

(http://bilbo.economicoutlook.net )

There is clearly the additional problem of debt which is now denominated in euros, because, as Mitchell notes, the problem because the nation that wanted to exit would have to deal with a foreign currency debt burden, and might find itself involved in a painful adjustment process in which the departing nation is forced to experience a punitive negotiated settlement (unless of course it was able to engineer payment in the new local currency).

Personally, we think the whole euro zone system is an abomination and would prefer to see all euro zone states go back to national currencies and thereby get their respective economies back on track with renewed fiscal capacity. But there is also a short term expedient which might prove minimally disruptive to the European Monetary Union’s current political and institutional arrangements, but could well succeed in restoring growth and employment in the euro zone.

Within the euro zone, short of leaving, the most elegant adjustment mechanism is for the ECB to distribute 1 trillion euro to the national governments on a per capita basis. This proposal would operate along the lines of the revenue sharing proposals we recently advocated for the American states. The nation states of the euro zone would the instructions from European Council of Finance Minister (ECOFIN) and the ECB would then change the balances in all of the national member bank accounts, in effect increasing their assets, and thereby reducing debt as a percentage of GDP. 

Within the euro zone, this sort of a proposal would likely give the respective EMU nations more bang for their respective euros, given the more elaborate social welfare programs in the EU. There would be less pressure to "reform" them (i.e., cut them back) if the EU nation states debt ratios are correspondingly lower and "compliant" within the bounds of the SGP.

The per capita criteria deployed here means that we are neither discussing a bailout per se of one individual country, and nor a 'reward for bad behavior.'  All countries would receive funds from the ECB on a per capita basis, which means that Germany would in fact become the biggest beneficiary.  The fact that all countries are in the euro zone means there's no possibility of Germany losing competitive ground to Spain or other low wage countries.  It would immediately adjust national govt. debt ratios substantially downward and ease credit fears. 

If there is no undesired effect on aggregate demand/inflation/etc., which there should not be given the prevailing high levels of unemployment in the euro zone, it can be repeated as desired until national government finances are enhanced to the point where they can all take local action to support aggregate demand as desired.  

The proposal advanced is the most institutionally elegant solution because it maintains the current arrangements, as flawed as they are, and preserves the euro.  Yes, a weaker euro would almost certainly result from this action. However, as "national solvency" is an issue for the euro countries (in a way that it is not for the US or Japan or the UK, given that the euro zone nation states are functionally more like American states than independent countries with their own freely floating non-convertible currencies), the resultant higher export growth that comes from a weaker euro is actually benign for everybody, as it minimizes the markets' solvency concerns. 

The formation of the European Union has been largely driven by the extremism of inter-European conflicts that caused millions of people to be slaughtered during two disastrous world wars. Ironically, the political and economic arrangements that have arisen in response to these horrors are creating a different kind of social devastation which is both wholly self-inflicted and profoundly misconceived.   Europe’s very currency could well blow up.  The US might well preserve its currency, but the EU’s current situation provides a salutary warning of what can happen  in a system that prevents individual member’s from using fiscal policy to improve the circumstances of their citizens.