Ashoak Upadhyay

Europe's strange tryst with history

ASHOAK UPADHYAY | Updated on May 22, 2012

An unsettling past is catching up on Europe. In 2014 the European Central Bank will have to decide on its refinance programme. That year will also mark the 100th anniversary of the dissolution of the last durable European formation.

In late December 2011 Mario Draghi, head of the European Central Bank, thought to unfreeze Europe's capital markets through a three-year funding programme, Longer Term Refinance Operation (LTRO), in which roughly euro 1000 billion was pumped into the system through some 1000 banks across Europe.

The markets revived with such funds, and so did those funds-starved governments with banks parking their fresh liquidity in sovereign debt at higher interest rates than the ECB's own lending costs. The bonds will have to be redeemed by end 2014 and the fear is that Europe may have just entered, via the LTRO into a three-year financial crisis cycle: the first in 2008, then in 2011 that led to Mr. Draghi's bailout plan of LTROs.

A Ponzi-like plan

In his Carnegie Endowment lecture recently, Mr. Kaushik Basu spoke at length about the prospects for Europe three years hence and its impact on India.

For the chief economic advisor to the finance ministry, the ECB plan is a Ponzi scheme meant to run one more round till 2014.

The ECB lends to the banks some $1.8 trillion and the banks promptly lend most of it to governments. In a word, the ECB's LTRO revives not just the banking system but indirectly the sovereign debt market that had virtually collapsed following the Greek crisis in 2010.

As Paul de Grauwe of the London School of Economics argued in his paper, How not be Lender of the Last Resort (CEPS Commentary March 23, 2012), the ECB's injections of liquidity may have revived the banking system and restored confidence in the sovereign bond market, but it has done so at a heavy price of uncertainty. The Greek insolvency crisis created a panic, its bonds were sold and investors fearing a similar fate in neighbouring countries sold bonds of other ‘peripheral' governments.

The sovereign debt crisis, the author argues, created the banking crisis. The LTRO operation, argues creates the ground for another round of crisis as an extremely edgy banking system takes sovereign debt onto its books.

Direct or indirect lending?

In 2010, De Grauwe argues, the ECB should have tackled the heart of the problem — the sovereign debt crisis — instead of waiting for the effect to take its toll on banks. Instead of asking banks to take on the responsibility of reviving the sovereign debt market, De Graauwe would have preferred the ECB to do so, financing instead of refinancing governments.

In the event, banks still “in a state of fear” have not lent all that they received to governments, a reluctance that forced the ECB to pump in additional funds. De Grauwe finds this inefficient: had it undertaken the direct route in the first instance its funds would have the desired effect of reviving the sovereign debt market.

No wonder, Mr. Basu calls this a Ponzi scheme; the danger that in 2014 debts may not be honoured may prompt the ECB to another round of refinancing to stave off a crisis in both sovereign debt and the banking system.

As a remedy he argues for a series of reforms to curb the fiscal deficit and some sort of fiscal compact.

In de Grauwe's analyses, troubles are already evident; a two-fold crisis is built into the ECB refinancing scheme.

On the one hand, banks haven't lent all to the governments; on the other they are plagued by the uncertainty of governments to meet their commitments; “new waves of panic” may prompt banks to “massively” sell off government bonds even before 2014.

De Grauwe sees greater moral hazards in the ECB's indirect lending programme; not only do banks remain reckless, so do governments, as both are aware of the ECB's tendency to pump money into banks.

Dealing directly with governments' debt, taking them onto its balance sheet rather than on banks' books, would lessen uncertainty.

Whether it will ease the Eurozone out of its crisis, De Grauwe does not say.

In that sense, MrBasu in his Carnegie Endowment lecture was more hopeful; should the Zone engage in some reforms on deficits and fiscal compact, the crisis awaiting it three years hence might just get mitigated

The problem however is that steps to reduce fiscal deficits in the peripheral countries have pushed them deeper into recession and, “renewed distrust in financial markets”, as De Grauwe dourly notes.

For Mr. Basu 2014 is the watershed year; the LTRO bonds would have to be redeemed and India runs into general elections. It is the year of convergence for both, the high point, when the results of past practice, errors and omissions, will come into play.

1914 and 2014

But for the Eurozone and the larger union, 2014 should also mean something more profound. On 28 June 1914, at Sarajevo, Gavrilo Princip fired at Archduke Franz Ferdinand, heir to the Austro-Hungarian throne.

The First World War ensued that, in turn, was to end the Dual Monarchy, the most durable European formation till then.

The Austro-Hungarian empire, Kakania of Robert Musil's great novel, The Man without Qualities, had been shaky for decades on account of its restless peripheral principalities on its southern borders smarting under Austrian (Teutonic) hegemony.

The economic crisis and political fissures continue to mount in the Eurozone, mainly on account of the problems on the Eurozone's southern borders.

There is a the distinct possibility of the latest European formation after the Hapsburg Empire coming unstuck on the shoals of German intransigence over reforms — like unsettling echoes of a lost world.

Published on May 22, 2012

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