In old Rome, debts were to be settled by the Ides of March – March 15. In Italy this year, as that legendary day of reckoning approached, questions about repayment obligations weighed on the minds of decision makers in the Eternal City.
In February, the European Commission issued another of its periodic warnings about Italy’s towering debt to GDP ratio – at 140%, after Greece, the second highest in the Eurozone. For a country that must go to markets to refinance a fifth of its obligations every year, the public admonition was awkward. But soon the swift and terrifying advance of COVID-19 across the historic towns of northern Italy brought new and much deadlier pressures. As emergency quarantines put out the lights in the piazzas and factories of one town after another in Italy’s industrial heartland, the economy ground to a halt and tax collections plummeted.
Italy’s fragile governing coalition now faces staggering budget challenges. A country already groaning under the weight of older debts now has to pile on still more liabilities to keep its people alive and to prevent sputtering businesses from collapsing.
A long time ago, Brutus and his accomplices delivered the “unkindest cut of all” to Julius Caesar on the Ides of March: In 2020, it came three days earlier. With markets in Europe and the rest of the world in free fall, Christine Lagarde, the new but very experienced President of the European Central Bank (ECB), emerged to sum up what the bank’s board had just decided to do. Anxious investors looked forward to reassurance in the style of Mario Draghi’s famous “whatever it takes” promise that had soothed turbulent markets back in 2012, when the Eurozone looked to be coming apart.
Lagarde did outline a series of measures to ease “liquidity” and encourage banks to lend. But then she added a remark that echoed around the world, declaring that the ECB “is not here to close spreads.”
Everyone grasped the implication: Italy, and perhaps other Eurozone countries facing similarly severe budget challenges down the road, had to watch out. They could not count on the ECB to hold down their funding costs.
The shock was global and profound: Eurozone stocks plunged yet again, while rates on Italian debt rocketed upward, in what some touted as the greatest one-day rise in the country’s history. The prospect that bond prices (and thus interest rates) of different countries in the Eurozone might diverge wildly, presaging a breakup of the zone itself, suddenly became real again.
Reaction in Italy was volcanic, with some angry economists comparing the new policy to a crime or an act of war. Elsewhere, press accounts of Lagarde’s performance were more guarded. Incredulous analysts struggled to explain it, usually opining that she must have made some kind of gaffe. The head of the Spanish central bank, who doesn’t run the ECB, jumped in to offer some reassurances, while Lagarde herself remarked delphically that she remained committed to stability, too, even if she was disinclined to spell out what that meant.
Soon it became obvious that talk of a mistake was misleading. In an interview with the Frankfurter Allgemeine Zeitung (FAZ), the head of the Bundesbank, Jens Weidmann, strongly defended the ECB’s actions: “We have done what a central bank in a crisis is supposed to do first and foremost: we have provided a generous supply of liquidity to the banks.” Asked a follow up question by the interviewer, Weidmann focused his response on Germany: “German banks have increased their capital and are well supplied with liquidity.” Then he changed the subject, adding that “precisely because of the budgetary discipline of recent years Germany has extensive leeway within the framework of existing European and national rules.”[1]
Within a day, what the German government (if not other countries in the Eurozone) could do with such leeway became starkly clear. Finance Minister Olaf Scholz and Economy Minister Peter Altmeier appeared together to announce measures that out-Draghied Draghi – but just for Germany. Scholz specifically invoked then U.S. Treasury Secretary Hank Paulson’s comment during the 2008 financial crisis that it was time to fire a big “bazooka.” The pair announced that the German government would make “unlimited” credit available to tide German businesses through the epidemic. Altmeier added later that the state might even take positions in companies if that were necessary. The German state, that is, was guaranteeing not just banks, but banks’ counterparties.[2]
In Eurozone, the situation is now untenable. Yes, European Union (EU) officials are offering to allow individual countries to temporarily breach the Eurozone’s constraints on budget deficits to allow emergency fiscal expansion. European bank supervisors and finance ministries are also signaling their willingness to go easy on individual banks as their debtors fall behind in payments. But those measures do not solve the basic problem confronting countries weaker than Germany whose economies are being decimated by COVID-19.
As many economists, including more than a few writing for INET, have recounted, the long running Euro crisis has created deep patterns of center-periphery dependence within Europe.[3] Basically Germany and a handful of other northern countries form the core, and everyone else, especially in the south, constitutes the periphery. Germany routinely ignores pro forma injunctions from Eurozone officials and outside analysts to rein in its current account surplus by expanding German domestic spending. This would stimulate imports from its partners and allow its own population to live better. Instead Germany keeps piling up enormous trade surpluses, while leaving many of its trading partners with even higher debts. With their economic growth slowed to a crawl, capital and younger workers in the periphery flee to richer countries, leaving behind economies whose productivity is too weak to make good their debts to foreign and domestic banks. When we factor in restrictions on budget deficits and state spending that the macroeconomic rules of the Eurozone prescribe, the result is deep, persisting austerity that cripples hope of effective state action in the south to stimulate growth and a vicious circle of demoralizing cuts in social spending and services, including education and public health, that afflicts even some northern countries.[4]
The refusal by Lagarde and the ECB to commit to stabilizing spreads within the Eurozone means that other, weaker countries cannot take measures like Germany’s to stabilize their economies and rescue the population. As the reaction to Lagarde’s announcement showed, absent Draghi-like assurances that the ECB will stand behind their debts, borrowing rates in the peripheral countries immediately take off.
At that point, thanks to the bizarre monetary constitution of the Eurozone, three doom loops all start operating. Firstly, as the weaker countries borrow more and more, their costs of borrowing shoot up. That requires them to shell out more for the same amount of principal and pulls down their credit ratings, adding to their refinancing problems.
But as Athanasios Orphanides, former governor of the central bank of Cyprus, has lucidly explained, the ECB also follows a perverse rule for bond buying that in emergencies can become deadly.[5] In 2005, when France, Germany and other countries pointedly ignored the fiscal restrictions enshrined in the original Stability and Growth Pact, the ECB responded by incorporating private credit-rating agency evaluations of debt into its decisions about what kind of collateral it would accept in return from individual countries for extending them support. That’s quite a shock: a supra-governmental agency leaving it to private parties to chart its course is the opposite of stabilization. It virtually defines the Eurozone as a bankers’ union and leaves private credit ratings swinging back and forth over countries like the sword of Damocles.
When private ratings agencies signal thumbs down, the ECB is supposed to reduce or eliminate altogether its support for individual countries. That has a strong pro-cyclical effect: fear itself becomes a deadly force that can and has led private investors to dump bonds of weak countries even if their positions look collectable in the long run.
But there is more – the third doom loop. In times of pressure, private banks inside any country must rely primarily on their central banks for support. The strength of a central bank depends, in the final analysis, on the strength of the country that operates it. For the ECB to take away a central bank’s line of outside support just as a crisis hits mocks the term “European” in the ECB’s name.
As the Greek case vividly illustrated, if the ECB won’t do business with a country’s central bank, that country’s entire banking system faces collapse. As one of us has shown in detail, European and national banking authorities have done little to clean up their banks, including, famously, the two German giants, Deutsche Bank and Commerzbank.[6] Weidmann is simply blowing smoke in the FAZ interview about the strength of German banks, but Germany can, if it must, likely tide the two giants over with a little help from EU banking supervisors. Italy is not so happily circumstanced. It has many weak banks and the cost of resolving their insolvency now threatens the state itself again.
In the U.S., despite the chaos that has marked the Trump administration’s handling of the pandemic, what will happen with regard to troubled individual states is still pretty obvious. Even if the President’s disdain for the American state apparatus continues to make trouble, each state will be able to draw on the resources of the whole country. The federal government, the Federal Reserve, and other regulators will – finally! – be working together. A considerable amount of aid will be dispensed without any strings attached and states will not be asked to pay back most emergency funds. Impulses by better circumstanced states to aggrandize themselves at the expense of weaker states are likely to be held in check. The challenge, in other words, is to treat the situation as a special case of catastrophic social insurance.
The contrast with the Eurozone is troubling and not just because of the self-righteousness of some German leaders. In recent weeks, suggestions have surfaced indicating that somebody in the EU may be contemplating a large bailout program for Italy, possibly the largest in world history.[7] Such programs have usually been conditioned upon agreements for draconian supervision and “conditionality” by European and other international monitors, such as the International Monetary Fund.
We think the record of these programs is disheartening. So we pray there is no thought of patterning the rescue of Italy or other countries in this crisis on the sorry experience of Greece. But earlier episodes in which the ECB and other European authorities used the ECB to bludgeon weak countries and enrich banks in the core are well documented.
It is plain that Europe is now on the brink of repeating the dreadful 1931 policies that froze the financial markets of Europe and pushed the world into a new and terrible downward leg of the Great Depression. The precipitating event for that crisis and the disastrous 1931 “Standstill Agreement” that came out of it, as Ferguson and Temin showed, was not the bankruptcy of the Austrian Creditanstalt – it was German internal politics.[8]
Germany today is vastly different from that late-stage Weimar regime. Right-wing groups stand mostly on the outside looking in and are in no way comparable to those that made such trouble in the twenties. German big business today is also heavily committed to an internationalist strategy, though recent talk about the need to lengthen the work day and the obsolescence of social partnerships by some business leaders is unsettling.
But the righteous bluster about previous austerity now allowing Germany to spend — and by implication no one else — is economic nonsense. A disaster of the dimensions that Italy and (we suspect) other European countries now confront requires massive, sustained spending to support the life and health of the population and efforts to restructure supplies in ways reminiscent of war economies. Peripheral countries have little hope of repaying loans of the sizes required when their economies can barely function at all. Claims that the ECB’s principal problem is to preserve liquidity in the banking system is mistaken. The first priority is to prevent a debt crisis from turning into a macroeconomic disaster.
Some news accounts report that Lagarde has been apologizing to members of the ECB’s board for her earlier comments. But these stories say nothing about other members of the board who publicly defended those views and who represent very powerful countries. In this situation, private discussions and public affirmations about liquidity are not good enough. The ECB needs to do whatever it takes to support the efforts of Italy and other countries to sustain themselves so that Europe gets through this crisis. Equally importantly, it needs to say this loudly and clearly, so officials in the peripheral countries can act.
The ECB should not allow more fortunate countries to preach austerity or help their banks and corporations to gobble up assets in the south at fire sale prices. Europe’s richer countries – Germany above all – need to emulate the spirit of the U.S. Marshall Plan from which they benefitted so much.[9] Aid they provide must not deepen debt dependence of the countries of the south; countries in the Eurozone should instead act together and contribute according to their ability to pay. We can imagine a variety of ways this can be done, but efforts to shoehorn Italy into a Greek-style conditionality program will almost certainly fail. They will unify the country and bring anti-European political forces to power, much as the 1931 disaster did in Germany.
As Americans, we have one further hope – that the U.S., too, will act more in the spirit of Marshall and not that of “America First.” We closely follow the Federal Reserve’s activities as the world’s lender of last resort, especially its provision of dollars to other central banks through swap lines with the ECB and other central banks. We also track the efforts of American banks to enhance their positions within the Eurozone. We would not be surprised if somewhere down the road, the swap lines became a factor in decisions by European bank regulators about whether U.S. banks can lead rescues of troubled European financial institutions.
The use of the swap lines needs much more discussion. Their proper use now would be to encourage the ECB to do what is actually best for Europe as a whole and not shut out countries in deep trouble. And it is high time that instead of talking about the evils of government and benefits of laissez faire, citizens in both Europe and the U.S. realize that new governing mechanisms are urgently required for the financial system: Taxpayers and ordinary citizens are always the silent equity partners of big banks and central banks. Medicare for All does not exist in the U.S., but single payer insurance assuredly does – for banks, courtesy of its citizens who rarely see any upside, but stand by at any moment to step in to absorb losses in a financial system that is now swollen so far out of balance that it can function only through hidden public guarantees.[10]
The authors gratefully acknowledge comments from numerous colleagues in the U.S. and Europe, but considering the nature of the piece, we preserve all but one person’s anonymity. Of course we are not speaking on behalf of any institutions with which we are affiliated.
[1] See Weidmann interview by Gerald Braunberger in the Frankfurter Allgemeine Zeitung, March 12, 2012, accessed March 16, 2020, https://www.faz.net/aktuell/wirtschaft/bundesbank-praesident-jens-weidmann-zum-coronavirus-16676519.html.
[2] Guy Chazen and Sam Fleming, “Germany Wields Bazooka in Fight Against Corona Virus,” Financial Times, March 14, 2020, accessed March 16, 2020, the event was the day before. Available at https://www.ft.com/content/1b0f0324-6530-11ea-b3f3-fe4680ea68b5. See also Frankfurter Allgemeine Zeitung, March 13, 2020, accessed March 16, 2020, https://www.faz.net/aktuell/wirtschaft/konjunktur/coronavirus-pandemie-regierung-sagt-kredite-ohne-begrenzung-zu-16677649.html?printPagedArticle=true#pageIndex_3; Der Spiegel, March 13, 2020, Altmeier interview by Martin Knobbe and Gerald Traufetter, accessed March 16, 2020, https://www.spiegel.de/politik/deutschland/peter-altmaier-cdu-werden-verhindern-dass-wirtschaftlich-gesunde-unternehmen-in-die-insolvenz-geraten-a-00000000-0002-0001-0000-000169988523.
[3] See, e.g., the references and discussion in Servaas Storm, “Lost in deflation: Why Italy’s Woes are a Warning to the Whole Eurozone,” Institute for New Economic Thinking Working Paper No. 94, accessed March 16, 2020, https://www.ineteconomics.org/research/research-papers/lost-in-deflation. Joseph Halevi’s series of papers analyzing the development of the Eurozone on the time are illuminating. See the collection at the INET website at https://www.ineteconomics.org/research/experts/JosephHalevi.
[4] See Giuseppe Celi, Andrea Ginzburg, Dario Guarascio, Annamaria Simonazzi, Crisis in the European Monetary Union: A Core-Periphery Perspective (London, Routledge, 2019); Orsola Costantini, “The Cyclically Adjusted Budget: The History and Exegesis of a Fateful Estimate,” INET Working Paper No. 24, accessed March 16, 2020, https://www.ineteconomics.org/uploads/papers/WP24_Costantini_1.pdf.
[5] Athanasios Orphanides, “Monetary policy and fiscal discipline: How the ECB planted the seeds of the euro area crisis,” Vox, March 9, 2018; accessed March 16, 2020, https://voxeu.org/article/how-ecb-planted-seeds-euro-area-crisis.
[6] Edward J. Kane, “Europe’s Zombie Megabanks and the Deferential Regulatory Arrangements that Keep Them In Play,” INET Working Paper, No. 64, accessed March 16, 2020, https://www.ineteconomics.org/research/research-papers/europes-zombie-megabanks-and-the-differential-regulatory-arrangements-that-keep-them-in-play.
[7] Ambrose Evans-Pritchard, “Fears Mount That Italy Will Require A Jumbo Global Bailout to Stem Broader Financial Contagion,” The Telegraph, March 10, 2020. We naturally use such sources with caution, but note the article quotes the former deputy director of the International Monetary Fund in Europe.
[8] Specifically, the decision of German political leaders, under massive pressure from right wing business and military forces, to repudiate reparations payments. See Thomas Ferguson and Peter Temin, “Made In Germany: The German Currency Crisis of 1931,” in Research in Economic History, Vol. 21, Alexander J. Field, ed. (Amsterdam: JAI, An Imprint of Elsevier Science, 2003), pp. 1-53; Ferguson and Temin, “Comment on ‘The German Twin Crisis of 1931,’” Journal of Economic History, Vol. 64, No. 3 (Sept. 2004), pp. 872-76.
[9] Or perhaps more exactly, the myth of the Marshall Plan. This in fact contained various constraints designed to nudge recipients in directions the U.S. wanted them to go, including a network of local administrators. But many of its funds were lent out in local currencies. In countries whose currencies depreciated, repayment was accepted in that diminished currency. At the end of the program, countries whose currencies appreciated were allowed to keep the money and plow the funds into various educational and philanthropic efforts. Presumably supranational institutions like the ECB and EU can do better. Special thanks to Walker Todd for comments on this part of the discussion.
[10] See the discussion and empirical evidence of the value of government implicit guarantees for large banks in Armen Hovakimian, Edward Kane, and Luc Laeven, “Tracking Variation in Systemic Risk at US Banks During 1974-2013,” INET Working Paper No. 16, accessed March 16, 2020, https://www.ineteconomics.org/research/research-papers/tracking-variation-in-systemic-risk-at-us-banks-during-1974-2013.
