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Tuesday, March 10, 2015 2:18 AM

From ZIRP to NIRP: Virtues of Germany vs. the Vices of Greece; What About "Speece" and Gold?

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Virtues of Germany vs. the Vices of Greece

At the heart of the constant bailout bickering in Europe is a fundamental, but seriously misguided notion that a battle is underway between the virtuous and fiscally responsible Germans and the irresponsible Greeks, Spaniards, and Portuguese.

In this incorrect view, the Spaniards have begun to see the light, but the Greeks need a serious lesson in morality.

If we step back and actually assign blame, we can find plenty of blame to go around.

"Speece" (my term for the Southern eurozone deficit countries of Spain, Greece, Portugal etc.) made many mistakes, but so did Germany.

It's logically impossible to believe "Speece" was a horrendously imprudent borrower, while simultaneously holding the view that Germany was a prudent lender.

More importantly, neither imprudent borrowing nor imprudent lending is at the heart of the eurozone problem.

Background Notes

Some snips from this post are from an email from Michael Pettis at Global Source Partners. Pettis' email contained a 32 page PDF that I will attempt to condense down to a couple pages, while adding a few pages of my own on topics he missed or went over lightly.

Except where noted, anything below in blockquotes is from Michael Pettis. Emphasis throughout is mine.

In regards to comments from Pettis, he says "As my regular readers know, I generally refer to the two different groups of creditor and debtor countries as 'Germany' and 'Spain', the former for obvious reasons and the latter because I was born and grew up there, and it is the country I know best.

Thus any comment from Pettis on "Spain" may mean "any eurozone debtor" and any comment on "Germany" may mean "any eurozone creditor".

I occasionally use the term "Speece" in the same way.

In context, sometimes Pettis says "Spain" and means "Spain". It's usually clear.

Moral Battle Update 

On February 27, the German Bundestag approved Greece's bailout extension request, but acrimony remains high.

For example, the Financial Times noted Germany’s biggest selling newspaper Bild attacked the Bundestag's decision to extend the bailout, with a front page on headline “Bild readers say No – no more billions for Greece.”

In the Bundestag, Klaus-Peter Willsch, a CDU legislator and longstanding bailout critic, launched a personal attack on the Greek prime minister and finance minister.

Look at [Alexis] Tsipras, look at [Yanis] Varoufakis, would you buy a used car from them? If the answer is no, then vote no today,” said Willsch.

And during the intense negotiations between Greece and Germany ahead of this vote, the parliamentary caucus leader of German Chancellor Angela Merkel’s Christian Democrats, Volker Kauder, told reporters "Germany bears no responsibility for what happened in Greece. The new prime minister must recognize that."

No Responsibility?

Does Kauder really believe Germany has "no" responsibility? Does finance minister Wolfgang Schäuble who has made similar-sounding statements believe that?

Whether or not Kauder and Schäuble believe their statements, people hear them again and again. Over time, such statements become conventional wisdom.

From Pettis ...

Nationalist Dreams

European nationalists have successfully convinced us, against all logic, that the European crisis is a conflict among nations, and not among economic sectors.

While distortions in the savings rate are at the root of the European crisis, many if not most analysts have failed to understand why. Until now, an awful lot of Europeans have understood the crisis primarily in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility.

This interpretation is intuitively appealing but it is almost wholly incorrect. And because the cost of saving Europe is debt forgiveness, Europe must decide if this is a cost worth paying (and I think it is).

Yet, as long as the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost.
Savings Rate Distortions
From 2000-04 Spain ran stable current account deficits of roughly 3-4% of GDP, more or less double the average of the previous decade. Germany, after a decade of current account deficits of roughly 1% of GDP, began the century with slightly larger deficits, but this balanced to zero by 2002, after which Germany ran steady surpluses of 2% for the next two years.

Everything changed around 2005. Germany’s surplus jumped sharply to nearly 5% of GDP and averaged 6% for the next four years. The opposite happened to Spain. From 2005 until 2009 Spain’s current account deficit roughly doubled again from its 3-4% average during the previous five years.

The numbers are not directly comparable, of course, but during those four years Spain effectively absorbed capital inflows above its “normal” absorption rate equal to an astonishing 21-22% of GDP from 2005 to 2009, and of 31- 32% of GDP from 2000 to 2009.

It wasn't just Spain. In the 2005-09 period, a number of peripheral European countries experienced net inflows of similar magnitude.

In principle, it isn’t obvious which way causality ran between capital account inflows and current account deficits (the two must always balance to zero).

To put it differently, German money might have been “pushed” into these countries, as the “blame Germany” crew has it, or it might have been “pulled” in, by the need to finance their spending orgies, as the “blame anyone but Germany” crew insist. For those who prefer to think in more precise terms, Germany either created or accommodated the collapse in Spanish savings relative to Spanish investment.

If it were the latter case, however, it would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time.
Push vs. Pull

I think we can look at push vs. pull another way. To pull credit, one bids up the interest rate. To push credit, one pushes the interest rates down.

From the push-pull interest rate point of view, the "blame Germany" crowd has the better argument.

Arguments Against Debt Forgiveness

Pettis provides a number of widely used arguments against debt forgiveness.

The arguments boil down to a couple of primary beliefs. Most have heard one or both of the following.

  1. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity. To forgive debt would create a moral hazard.
  3. Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless investment projects. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of its leaders, but ultimately Spain is responsible.
Question of Choice

Was there really a choice? Did Speece make these mistakes acting alone or because of  "venality of its leaders".

Pettis answers ...

Blaming Nations
Because German capital flows to Spain ensured that Spanish inflation exceeded German inflation, lending rates that may have been "reasonable" in Germany were extremely low in Spain, perhaps even negative in real terms. With German, Spanish, and other banks offering nearly unlimited amounts of extremely cheap credit to all takers in Spain, the fact that some of these borrowers were terribly irresponsible was not a Spanish "choice".

Couldn't Spain have refused to accept the cheap credit, and so would not have suffered from speculative market excesses, poor investment, and the collapse in the savings rate?
Not really. Pettis explains ...
"There is no such a decision-maker as 'Spain'. As long as a country has a large number of individuals, households, and business entities, it does not require uniform irresponsibility, or even majority irresponsibility, for the economy to misuse unlimited credit at excessively low interest rates. The experience of Germany after 1871 suggests that it is nearly impossible to prevent a massive capital inflow form destabilizing domestic markets."

As German money poured into Spain, with Spain importing capital equal to 10% of GDP at its peak, the massive capital inflows and declining interest rates ignited asset price bubbles.
Pro-Cyclical Feedback Loops

Spain could not stop these pro-cyclical feedback loops of massive proportion because Spain did not have control over its own interest rate policy or currency.

Instead, the ECB had an interest rate policy best described in my opinion as "one size fits Germany".

The bubble-blowing feedback loop fed on itself until it blew up. Who is really to blame for that?


No discussion of eurozone problems would be complete without a discussion of Target2, an abomination created by the eurozone founders and one of the fundamental flaws of the euro.

Target2 stands for Trans-European Automated Real-time Gross Settlement System.

It is a reflection of capital flight from the "Club-Med" countries in Southern Europe (Greece, Spain, and Italy) to banks in Northern Europe.

Pater Tenebrarum at the Acting Man blog provides this easy to understand example: "Spain imports German goods, but no Spanish goods or capital have been acquired by any private party in Germany in return. The only thing that has been 'acquired' is an IOU issued by the Spanish commercial bank to the Bank of Spain in return for funding the payment."

Also, if people in "Speece" no longer trust their banks, they pull their deposits and park them elsewhere.

Channel for Capital Flight

PIMCO explains Target2 as a Channel for Capital Flight.
​The EU’s loans to Greece, Ireland and Portugal are just the tip of the iceberg of a fledgling transfer system that is creeping into the eurozone via the back door. A far bigger and implicit subsidy is growing beneath the surface in the form of TARGET2.

When the European Central Bank (ECB) creates money, as it currently is doing in grand style, it must end up somewhere. The allocation of TARGET2 balances among the seventeen national central banks, which together with the ECB make up the Eurosystem, reflects where the market allocates the money created by the ECB. The fact that the Bundesbank has a large TARGET2 claim (asset) on the Eurosystem, while national central banks in southern Europe and Ireland together have an equally large TARGET2 liability, simply reflects that a lot of the ECB’s newly created money has ended up in Germany. Why? Because of capital flight.

Countries in southern Europe generated persistent current account deficits since joining the euro in 1999, some of them large. A current account deficit means a country spends more in total than it earns. That extra spending is financed by borrowing from abroad. The source for such borrowing comes from a current account surplus country, like Germany. Since the euro eliminated exchange rate risk among its member states, Germany has invested a substantial portion of its savings in Europe’s current account deficit countries. Some of those savings are now returning home. That’s the capital flight.

Enter the ECB. The ECB stepped into the void left by foreign investors pulling their savings out of these current account deficit countries by lending their banks more money. TARGET2 balances thus reflect intra-Eurosystem credits among the national central banks sharing the euro. When large capital flight to Germany occurred before the euro’s introduction, the deutschemark would appreciate against other European currencies. While pegged against the deutschemark, these exchange rates were still flexible. That flexibility disappeared with the euro.

When capital flight occurs today, the Bundesbank effectively ends up with loans to the other national central banks that are reflected in the TARGET2 claims on the Eurosystem.
Target2 Imbalances

Chart courtesy of Euro Crisis Monitor.

As of January 15, 2015, the Target2 numbers look like this, in billions of euros:

Germany 515.266

Key Target2 Numbers

  • Germany has a Target2 surplus of €515 billion.
  • Greece has a target2 deficit of €76 billion.
  • Spain has a target2 deficit of €192 billion.
  • Italy has a target2 deficit of €164 billion.

The ECB treats all of these surpluses and deficits as if they were equal and as if they don't matter. Clearly they are not equal, and they do matter.

Role of Attitudes

It's not entirely true that attitudes played no role in this mess. Germans tend to view things quite differently because of their experience with hyperinflation in the 1920s.

Today, socialists rule France, Greece, Spain and other countries. Greece has a history of defaults.

To completely dismiss such items is wrong. But who bears responsibility? The Germans, the Greeks, the Spaniards? Speece?

The answer is the eurozone founders and the eurozone aggregate members.

Greece lied to get into the eurozone. But every country knew Greece lied. If they didn't, they should have. And if Germany knew Greece lied, who gets the bigger share of the blame?

More fundamentally, the eurozone founders knew full well there were serious productivity differences, work rule differences, pension differences, etc., etc., between countries. The eurozone founders mistakenly assumed that all the countries would get together and solve these issues. 

Oops. That is damn near impossible now because rule changes require consent of every eurozone country. The more countries that are added, the more difficult it is to get rule changes.

Currently a mass of rule changes are sorely needed on agricultural issues, work issues, pension issues, and literally dozens of issues. Any country can block reform.

Gold Standard

Of all the laughable analogies made about the euro, at the top of the list is the notion the euro acts likes the gold standard. One can find many writers making such claims.

For example, please consider Actually, There Is A Gold Standard Today, And It's Causing An Economic Catastrophe.

The post is fatally flawed, yet it does reflect conventional wisdom.

Here is a short rebuttal: Only in the superficial sense, that countries cannot debase their currency in isolation, does the euro remotely resemble a gold standard. On a practical and far more important basis, Target2 and the common interest rate policy are the opposites of what would happen on a gold standard.

Prior to Nixon closing the gold exchange window, countries running perpetual currency account deficits would see an outflow of gold they would eventually need to do something about.

In the eurozone, the ECB set interest rate policy (primarily for the benefit of Germany) and Target2 said the deficits of Speece do not matter.

Under a gold standard, no one would have lent his own hard-earned gold to Speece, without much higher interest rates and good collateral to secure the loan. This of course would have dampened appetite for borrowing.

Simply put, the eurozone setup was the exact opposite of what would have happened under a gold standard.

Still No Enforcement Mechanism, Anywhere

Because there were no trade imbalance enforcement mechanisms, Speece imbalances grew until they blew up. And until they blew up, the IMF had nothing but praise for Spain! And every step of the way, the IMF underestimated the problems Greece faced.

We are headed into the third Greek bailout, and the IMF remains clueless about Greece's ability to pay back "bailout" money.

Worse yet, there still is no "enforcement" mechanism anywhere in the world, and the structure of the euro is such that imbalances in Europe are even harder to fix than elsewhere.


In the US, we see chronic trade imbalances with China, Japan, and oil producers. We also see constant bickering as to whether or not to label China a "currency manipulator".

Every country is manipulating currency now, one way or another. China does so with pegs, most countries manipulate via interest rate policy.

The mad race to ZIRP has now gone to NIRP. Zero interest rate policy has morphed into negative interest rate policy in a global beggar-thy-neighbor scheme.

EFSF and ESM - Short Term Stabilizing, Long Term Destabilizing

The European Financial Stability System (EFSF), was created  in 2010 as a "temporary" crisis resolution mechanism. The EFSF provided financial assistance to Ireland, Portugal and Greece.

The ESM is supposedly a "permanent" crisis resolution mechanism. The ESM has provided loans to Spain and Cyprus.

Risk is shared by all eurozone member states in proportion to their share in the paid-up capital of the European Central Bank. That risk sharing is in clear violation of Maastricht Treaty no-bailout provisions, but few care about rules in time of crisis.

The problem with "risk sharing" is that every county is partially responsible for problems elsewhere. In short, Spain is partially responsible for Greece, and vice versa. This can lead to cascade effects if a country defaults on bailout obligation.

Dr. Eric Dor, director of IESEG School of Management in Lille, has an update on exposure to Greek debt liabilities.

The details are interesting.

IESEGBilateral loansGuarantees on the borrowings of EFSF to fund its loansImplicit share of TARGET2 claims of the EurosystemImplicit share in the SMP holdings of bonds by the EurosystemTotal

The above table is from Exposure of European Countries to Greece by Dr. Eric Dor, IESEG School of Management.

Note: The above table was produced at a different time than the Target2 balances that preceded it. There may be slight differences.

Spain which is in its own ESM bailout agreement is supposedly liable for €32.744 of Greek exposure. How is that going to work, besides not?

Some disagree (or more likely say they disagree because it suits their short-term needs), but these bailout agreements as structured are in clear violation of the Maastricht Treaty. At some point, this will come back to haunt those who dreamed up those schemes.

Problem is Not Virtue vs. Vice

Let's return to a statement Pettis made much earlier: To the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost.

Blame Assignment

Hopefully it is now clear the problem is not virtue vs. vice, but something far more complex. With that in mind, the question of the day is "how do we assign blame for problems in Speece?" In rough order, I propose ....

  1. No enforcement mechanisms
  2. ECB
  3. Target2
  4. Eurozone founders and eurozone rules
  5. Eurozone member states ignoring rules
  6. Attitudes

Most have attitudes at the top. I have attitudes at the bottom. I suppose one could summarize points 1-5 simply as the "eurozone flaws" or the "euro" but each is worth discussing separately.

Debt Dynamics

Pettis says "Even if the question of who is to blame, Greece or Germany, were an important one, the answer would not change the debt dynamics."

True enough.

In the end, Greece will not pay back, what cannot be paid back. Indeed, two haircuts have already been taken. The bickering now is whether or not there will be another bailout, and still further haircuts.

How do we know Greece cannot pay back the existing debt? The market tells us so. Ironically, by the time the market makes it clear there is a huge problem (yields soar for example), it's too late to do much of anything but assign costs.

Said Pettis, "My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume."

Rise of Fringe Parties

Curiously, one of the biggest finger-pointers in this mess now is Spain. The Financial Times talked about it in Spain Keeps Hawkish Eye on Greece as Southern Solidarity Crumbles.

"In its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the
'virtuous' countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter," said Pettis.

Solidarity Where?

On Monday March 2, acrimony took another huge step forward as Greek premier Alexis Tsipras accused Spain and Portugal of sabotaging negotiations.
“We found opposing us an axis of powers ... led by the governments of Spain and Portugal which, for obvious political reasons, attempted to lead the entire negotiations to the brink,” Tsipras told party members on Saturday.

Their plan was, and is, to wear down, topple or bring our government to unconditional surrender before our work begins to bear fruit and before the Greek example affects other countries… And mainly before the elections in Spain.
Prime minister Rajoy responded "We are not responsible for the frustration generated by the radical Greek left that promised the Greeks something it couldn’t deliver on."

Spanish Prime Minsiter Mariano Rajoy is making a big mistake. Spain can use debt relief. And the citizens of Spain want debt relief.
By taking a hard stance in favor of Berlin, Rajoy adds fuel to the rise of Podemos. Siding with Germany is the wrong thing to do if Rajoy wants to win reelection.

Playing with Fire

Tsipras is a close friend and political ally of Pablo Iglesias, the former political science lecturer who founded Spain’s anti-establishment Podemos movement.

Podemos is currently in the lead in Spanish polls. Elections are later this year.

Rise of Extreme Parties

Check out the rise of "extreme parties".

  • Syriza in Greece
  • Golden Dawn in Greece
  • Podemos in Spain
  • Five Star Movement in Italy
  • National Front in France
  • AfD in Germany
  • New Fins in Finland

In that group there are leftwing and rightwing parties, but all have one thing in common: They are sick of something. Spain is supposedly in recovery. What are Spaniards upset about? Greeks?

Spanish Unemployment

Spanish Youth Unemployment

Greek Unemployment

Greek Youth Unemployment

Unemployment is a huge problem. Growth alone will not cure this problem. Both Spain and Greece are growing now.

High unemployment rates in Speece will remain for a long time unless there is debt forgiveness or Germany turns its current account surplus into a deficit for the express benefit of Speece.

Speece cannot become more like Germany, unless Germany becomes less like Germany and more like Speece.

Third Bailout or Grexit

I believe a third bailout and a third restructuring of Greek debt is necessary (See
Third Greek Bailout? Another €53.8 Billion Needed? Primary Account Surplus Revisited).

Will Greece go along? Slim chance, unless "bailout" truly means bailout, not more debt.

Will Germany go along? The answer is almost certainly no. That means a Grexit or a default in June when this extension ends.

Can the Euro Be Saved?

Pettis says "Europe must decide if this [debt forgiveness] is a cost worth paying (and I think it is)."

I do not believe it's that simple (and that is not by any means simple).

Here's a better way of looking at things: "Is the euro so fundamentally flawed, and tensions so high that the euro cannot possibly be saved at all?"

I believe the answer to that question is yes.  If it is yes, then discussion better begin soon on how to exit from this mess.

If the answer is no, then someone needs to explains what it will take to get Germany to forgive enough debt to allow Speece to grow without perpetually high unemployment rates.

There are only three possible paths at this point.

Three Alternative Paths

  1. Enough debt writeoffs to allow Europe to grow
  2. High unemployment and slow growth in Speece, with stagnation elsewhere in Europe
  3. Breakup of the eurozone

There are no other realistic choices. Interestingly, none of them fixes the fundamental problem of "no enforcement mechanism" anywhere in the world.

 Let's turn now to the source of that particular problem.

Nixon Closed the Gold Window

The last semblance of enforcement mechanisms vanished when Nixon "temporarily" closed the gold window in 1971, refusing to let foreign central banks redeem their dollars for gold.

What else happened at the same time?

If you guessed debt soared as did income inequality, you guessed correctly.

Income Inequality

The above chart from The Rise and Fall of US Income Inequality (annotations in purple added with a hat tip to zero hedge for the idea).

Gross Federal Debt

Beggar Thy Neighbor

Nothing is in place anywhere to stop "beggar thy neighbor", competitive currency debasement, competitive QE, negative interest rates, and all sorts of other amazing distortions brought about by central bank policies in general, not just in Europe.

History suggests nothing will happen until there's a crisis.

We did not use the last crisis well. Global debt went up $57 trillion dollars or so since 2007 (see Seven Years Later, Global Debt Keeps Piling Up, $57 Trillion More Than 2007)

There was no deleveraging anywhere. And the leveraging up was certainly not for the benefit of the 99%.

Consumer Price Deflation vs. Asset Deflation

In their inane attempt to prevent consumer price deflation, the world's central banks have spawned massive asset bubbles in equities, junk bonds, and housing.

When those bubbles burst, they will spawn the extremely destructive asset deflation that central bankers ought to fear, but never do because central bankers never see the bubbles they create until they burst wide open.

Currency Crisis Awaits 

Global imbalances are so extreme, interest rate policy so absurd, and unsound fear of consumer price deflation that a massive currency crisis is all but inevitable now.

The currency crisis could start in Europe. But it could also start in Japan, the UK or anywhere.

Meanwhile, as long as there is no enforcement mechanism on spending and on trade imbalances, the bubbles will grow and grow and grow until central banks can no longer stuff anymore debt into the system.

Good luck when the bubbles pop. Let's hope the next crisis is handled better than the last one.

Don't count on it, especially when ...

  1. Central banks do not see themselves as part of the problem
  2. The 1% want to keep the status quo
  3. The Keynesians believe more spending is the answer to too much debt
  4. The Monetarists believe more printing is the proper response to too much printing
  5. The academics blame the 1% instead of the Fed (central banks).

Mike "Mish" Shedlock

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