Why do European taxpayers continue to bail out eurozone banks ?

Watching IMF representatives and European policy makers bicker about whether Greece will attain some randomly determined benchmark or another by 2020 is akin to watching a scenario in a nuthouse. What makes me furious is the fact that the attainment of arbitrary benchmarks thought up by some non-elected bureaucrats determines the release of desperately needed financial assistance for Greece, and thus the fate of millions of suffering Greeks. 

Which brings me to my initial question: why are eurozone banks still being bailed out while the people in the Southern European periphery have to suffer under the troika's inhumane and economically non-sensical austerity policies ? Before attempting an answer to this question, let me provide some evidence for the dirty secret that, four years after the onset of the Great Financial Crisis, eurozone banks still need taxpayer support in the trillions (compare Yanis Varoufakis, "Europe after the Global Minotaur"):

• The ECB's long-term refinancing operation (LTRO) in late 2011 and early 2012 lent 1 trillion Euro to eurozone banks at 1% interest in exchange for questionable collateral in the form of sovereign bonds.  This highly lucrative operation for eurozone banks was designed to motivate banks to purchase Spanish and Italian sovereign bonds paying anywhere from 5% to 7% interest. It worked.  Between the end of 2011 and July 2012, european lenders increased their assets from $42 trillion to $45 trillion (see graph below).

• The March 2012 partial write-off of Greece's debt held by banks and private investors (the so-called PSI or private sector involvement) represents a huge subsidy for banks and a transfer of private investment risk to the public sector, i.e. the European taxpayer. Even though the market value of Greek bonds was discounted by 70-80% before the write-off, banks had to take a haircut of only 20%-30%, implying a taxpayer subsidy of between 50%-60%.
  
• To add insult to taxpayer injury, the new sovereign bonds issued in exchange for retiring the old, nearly worthless ones are guaranteed by the EFSF, i.e. European taxpayers. Thus, 65% of Greek credit risk (€194 bln out of €300 total) has been smoothly transferred to the European taxpayer. And Greece, by the way, ended up with a higher debt burden than before due to new loans it had to take on to repay the troika creditors.
  
• In August 2012, the ECB announced that it would buy an unlimited amount of sovereign eurozone bonds on the secondary market to keep interest rates and, thus, financing costs low for the countries concerned (mainly Spain and Italy). The dirty secret behind this operation lies in the fact that the ECB purchases raise the market value of these bonds held by banks and private investors, thus providing another taxpayer-financed subsidy. 

All in all, the corporate welfare payments to eurozone banks may cost European taxpayers hundreds of billions of euros, if not more, and the money does not even benefit the people who, by contrast, have to suffer dramatic cuts in wages and public pensions to free up money for their country's debt service and to improve competitiveness. 

So what explains this crazyness and why is it that the eurozone's financial sector has not been forced to deleverage and close down zombie banks instead of keeping them alive with taxpayer money ? 

Enter the Institute of International Finance

The answer to the question posed above might be found at the doors of an institution created 30 years ago, just two blocks from IMF headquarters in Washington DC, to represent the interests of the world's largest commercial and investment banks in debt restructuring negotiations with highly-indebted Latin American countries: the Institute of International Finance (IIF).

The IIF's membership in 1982 encompassed the eight largest US money center banks at the heart of the Latin American debt crisis: Citigroup, JP Morgan, Chase Manhattan, a.o. Today, celebrating its 30th anniversary, the IIF counts more than 450 members from over 70 countries, including a growing number of large insurance companies and investment management firms (regular IIF members) in addition to multinational corporations, trading companies, and multilateral agencies (associate IIF members). 

Until recently, the IIF was chaired by Josef Ackermann, ex-CEO of Deutsche Bank Group, who no doubt advised Charles Dallara, IIF Managing Director, the IIF representative during the Greek debt restructuring negotiations in early 2012. ....This might explain the very favorable terms banks got in the March 2012 PSI (see above). It might also be no accident that the IIF recently moved its headquarters close to the US Treasury, the most important player in the resolution of the 2008 Great Financial Crisis.

Despite its inconspicious name suggesting a research institute, the IIF's website until recently didn't hide its true mission: “being the most influential global association of financial institutions”, striving to fulfill this mission through the following activities (the mission statements below were taken from the website in 2011, they have since been toned down):

• “Systematically identify, analyze, and shape regulatory, financial and economic policy issues of relevance to our members globally or regionally.”

• “Develop and advance representative views and contructive proposals that influence the public debate on particular policy proposals, including those of multilateral agencies….”

• “Work with policymakers, regulators, and multilateral organizations to strengthen the efficiency, transparency, stability and competitiveness of the global financial system, with an emphasis on voluntary market-based approaches to crisis prevention and management.”

• “Provide a network for members to exchange views and offer opportunities for effective dialogue among policymakers, regulators, and private sector financial institutions."
  
  
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The fiscal multiplier and austerity in the eurozone

As I had mentioned in my post "What do recent events mean for the EU and economic policy in the eurozone?", part II and III, the IMF's World Economic Outlook of October 2012 presented new evidence of a larger than assumed fiscal multiplier, now found to be in the order of between 0.9 and 1.7, instead of 0.5 as previously estimated (see WEO 2012. chapter 1, box 1.1).

Before thís momentous concession that IMF economists had underestimated the fiscal multiplier, there were three different 'camps' regarding the impact of austerity on economic growth:

1.) The 'expansionary austerity' camp [fiscal multiplier = 0]

Proponents of the expansionary austerity view argue that fiscal contraction would not only NOT reduce economic growth, but might even enhance growth through exchange rate and confidence effects. The supply-side research papers of Alberto Alesina have been particularly influential in certain economic policy circles and were quickly picked up by European policymakers as a justification for the austerity programs imposed on Greece and other Southern European countries in return for EU financial assistance. While German finance minister Schäuble is a staunch supporter of the expansionary austerity school, Larry Summers thinks "that the idea of expansionary austerity is oxymoronic"...."you can drop the prefix." (see my post "Austerity chickens are coming home to roost in Germany").

2.) The mainstream camp [fiscal multiplier = 0.5]

This camp, which included the IMF and the Bank of England, held that the impact of austerity on economic growth would be significant, but only moderately so. Examining data from the last three decades, the IMF concluded in October 2010 that "fiscal consolidation typically lowers growth in the short term."...."we find that after two years, a budget deficit cut of 1 percent of GDP tends to lower output by about 1/2 percent and raise the unemployment rate by 1/3 percentage point." (see press points for chapter 3, World Economic Outlook 2010)

3.) The 'recessionary austerity' camp [fiscal multiplier > 1]

Economists in the third camp, including Paul Krugman, Brad Delong, Martin Wulf (Financial Times) and Simon Wren Lewis, argue that the experience of the last three decades is not relevant to today's liquidity trap environment. In a liquidity trap environment, central banks' injections of cash into the banking system fail to stimulate economic growth because banks and people hoard cash. As people expect insufficient aggregate demand and/or deflation, they prefer to hoard their money instead of investing or consuming it, so that the impact of monetary policy is either zero or very moderate due to its limitation by the zero lower bound of interest rates. In such a situation, only fiscal policy will have an impact on economic growth, with the fiscal multiplier most likely larger than 1. For the eurozone, this means that each €uro of fiscal austerity will reduce economic activities by >1 €uro, specifically by between €0.9 and €1.7.

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The chart above shows the liquidity trap as visualized in a IS-LM diagram. A monetary expansion (the shift from LM to LM') has no effect on equilibrium interest rates or output. However, fiscal expansion (the shift from IS to IS") leads to a higher level of output with no change in interest rates.
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Since October 2012 I believe it is fair to say that at least the IMF's Chief economist and his team of economists have moved from the mainstream camp to the recessionary austerity camp. Here is the key paragraph of their research findings on fiscal multipliers: "Our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession. This finding is consistent with research suggesting that in today's environment of substantial economic slack, monetary policy constrained by the zero lower bound and synchronized fiscal adjustment across numerous economies, multipliers may be well above 1."  (see WEO of October 2012)

What does all this mean for the eurozone ?

In view of economic developments in the eurozone since the Great Financial Crisis in 2008, one doesn't have to be an economist to conclude that ECB monetary policy has been ineffective in terms of its impact on economic growth: while interest rates reached historically low levels, economic activity has slumped in the periphery and slowed down in the core, with banks withholding credit and corporations postponing investments; with consumers foregoing consumption, prefering to put their money under the mattress or depositing it in other countries perceived as safe havens (predominently Germany, Luxemburg, or Switzerland).

Anybody with common sense can also observe that fiscal policy has had a severe impact on the economies of the eurozone's Southern periphery: In Greece, the fiscal contraction imposed by the troika to lower the country's debt in relation to its GDP caused a dramatic slump in GDP, from €249 bln in 2009 to €194 bln in 2012. Instead of lowering the debt ratio, the economic contraction increased the burden of Greek debt in relation to its dramatically lower GDP from 120% in 2009 to 176.7% of Greek GDP in 2012 (Eurostat data). This suggests that the fiscal multiplier has indeed been much larger than 0.5 as initially estimated by the IMF in 2010. Applying the IMF's revised multiplier estimate of 1.7, the new fiscal cuts of €13.5 bln just approved by the Greek parliament would lower Greek GDP by €23 bln to €171 bln, increasing the debt ratio to 203% of GDP ! At that point, Greece would need another €100 bln from the European taxpayer just to keep it going.

Similar fiscal multiplier effects can be observed in Spain and Portugal. Instead of putting the Southern periphery on a path toward sustainable growth, the austerity polices imposed by the troika have dramatically lowered the countries' GDP, thus increasing public debt ratios and creating a humanitarian crisis so dramatic that it provokes regular massive demonstrations against the inhumane spending cuts focused on the weakest members of society: the old, the young, and the poor. 

The conclusion is obvious to anybody but the Very Serious People in power: A continuation of the austerity policies in the eurozone worsen the debt burden and the humanitarian crisis in the countries of the eurozone's periphery, reinforce the trend toward violent opposition and foster the growth of militant, nationalist movements. These trends already threaten "Europe's cohesion and the ideals behind the European Union" (George Soros) and seriously endanger the 60-year peace period in Europe, mocking the recently awarded Nobel Peace prize.

Hence, it is urgent and indispensable to immediately STOP the austerity measures, take up Mr. Soros' offer to "commit serious financial resources", and design a more appropriate, sustainable, and humane economic adjustment strategy for the entire eurozone. 

Best-case economic scenario postponed

In my post "What do recent events mean for economic policy in the eurozone ? Part III" I defined the best-case scenario as a "new approach in economic policy", away from the current deflationary austerity toward a more humane, job-creating growth strategy, "with a completely different political coalition in Germany" and argued that the feasibility of such a scenario depended on the outcome of the primary of Germany's Green party.

Well, the Green party's primary results are in and suggest, unfortunately, that a U-turn in economic policy making in the eurozone is highly unlikely. Let me explain why:

Germany's Green party members have elected Jürgen Trittin and Katrin Göring-Eckhardt as their leaders for the 2013 parliamentary elections, two veteran politicians who during the last red-green government from 1998-2005 supported the economic policies of Agenda 2010: an employer-friendly, supply-side economic program of labor market reforms prepared by the global media conglomerate Bertelsmann Group and broadly supported by Germany's corporate interest groups (see my post: "Blueprint of labor reforms in Greece: Germany's Agenda 2010").

Katrin Göring-Eckhardt, a trained evangelical theologian without academic degree, career politician and Agenda 2010 supporter apparently does not see a conflict between the humanitarian values of the evangelical gospel and her support for the inhumane policies of Agenda 2010 which have thrown millions of German citizens into poverty and forced them into accepting menial jobs paying €1 an hour. Everybody can be excused for making mistakes, but the fact that she has not distanced herself from the inhumane Agenda 2010 policies, in my eyes, makes her untrustworthy and unelectable.

Trittin (a trained sociologist, career politician, and one of this year's invitees at the Bilderberg conference) is making some politically correct noises designed to attract progressive voters. Nevertheless, when push comes to shove, he would not shrink from making compromises with Germany's powerful corporate and financial 'elite' to gain and remain in power. While compromises are per se not objectionable, they are at a minimum questionable, if not criminal, with a German 'elite' that insists upon imposing its Schwabian housewife policies of deflationary austerity in the eurozone's Southern periphery, against all evidence that such policies throw the economies into a depression, worsen the debt ratios, and create a humanitarian crisis so severe that criminal charges have been filed against Ms. Merkel and the leaders of the troika for crimes against humanity.

Given that the only feasible alternative to a Merkel government in Germany is a red-green coalition led by a social (!) democratic chancellor candidate Steinbrueck who is currently engulfed in a controversy about his €1.5 million earnings from speaking engagements while many of his fellow party members barely make ends meet with yearly salaries of €25.000 (an amount that Steinbrueck received for just one speech), doesn't make me very optimistic for a positive change in economic policies in the eurozone.

Sadly,I guess the only viable alternative is to keep up the democratic pressure to force real change. As President Roosevelt said to the union leaders when they proposed plans to include in the New Deal: "I agree with you, I want to do it, now make me do it !" (FDR, 1932)

Germanic Economic Mythology - update Jan 2013

Since the 2012 release of Quentin Tarantino's Django Unchained the global movie audience is familiar with the story of Brunhilde and Siegfried (i.e. the German Nibelungen saga) as told by Dr. Schultz. It is my personal pleasure today to present to you the economic sequel of this saga:

The economic sequel features the current German approach to economic policy making based on what can best be described as Germanic Economic Mythology:

It serves four gods and goddesses, namely

1.) the Swabian housewife [most revered for her budgeting skills]

2.) financial markets [the evil twin of the Schwabian housewife]

3.) competitiveness [the mother of exports]

4.) free and flexible markets [esp. as applied to labor markets]

Assisting the gods and goddesses are the invisible fairies, namely

• the confidence fairy which helps motivate financial markets to invest
  and
• the invisible hand which guides market participants toward the equilibrium between supply and demand, even if it means poverty-level wages.

The gods and their fairies live in dark forests filled with dragons and zombies (zombie banks, the inflation zombie, cockroach zombies). While zombie banks are regularly fed with corporate welfare payments in the hope that they can be reanimated, Germans desperately fear that the inflation zombie comes back to life because it might turn into a fire-spewing dragon. That is why they prefer to beat it down even when it shows no signs of life at all.

Germans also fear another, even more horrible dragon with three ghastly heads: the public debt. Its largest head is the federal government's debt, including the obligations of the national pension fund. The other two heads include the regional debt and the debt of the communes.  

To slay the three-headed monster dragon public debt and prevent the inflation zombie from turning into a fire-spewing dragon, draconic sacrifices are made on the altar of the most powerful gods, the financial markets and competitiveness.The sacrifices preferred by the most powerful gods are wages and social welfare benefits such as unemployment benefits, health care benefits, public pensions and the like. If the three-headed monster dragon public debt is really large and endangers the lifestyle of the gods, the ultimate sacrifice may be required:  human dignity and human life.  

Statue of Siegfried slaying the dragon, Bremen.