Eurozone: Draghi’s Plan Isn’t Going To Work You Know

15 january 2013

Mario Draghi, head of the European Central Bank, has announced the plan to save the euro and the economies of the eurozone. Markets have risen on the idea that this is it, finally, the plan to end the crisis. And it’s almost there but not quite. And that not quite is going to mean, in my opinion at least, that it will fail:

Mario Draghi has done his bit. As promised, the European Central Bank will wade into the financial markets in an attempt to hold together the single currency until the politicians get their act together and agree on steps towards closer political union.

That’s the good news. The bad news is that the Draghi blueprint will not be enough to save the euro. The impression left by Thursday’s announcement on unlimited bond buying was that it was technically sound but based on flawed economics.

There’s much good stuff in there. The ECB will buy “unlimited” amounts of bonds to bring interest rates down to something manageable. That should mean that countries can finance at least part of their borrowing (and the most important part is being able to roll over debt coming due) on the markets. Further, the ECB has given up priority or seniority. This is important as without this, the more of the total debt issue they bought the lower the value of that in private hands: for if there ever was a default then all of it would have had to be on the private holders. As happened in Greece: a 70% haircut but by no means a 70% reduction in total debt burden as so much of the debt was held by official bodies with seniority.

All good so far. However, two further points, one minor and one I consider a deal breaker.

The minor one is is that they’re only going to buy short term bonds….up to three years. What this of course means is that the issuers will therefore be preferentially issuing such short term bonds. This lowers the maturity profile of the entire debt which is a real risk factor. It means that ever more has to be rolled over as time goes on. It also puts ever more power into the ECB’s hands (and thus the EU). As those debt maturities shorten then if the national government starts to step out of line….arguing about austerity for example…then all they have to do is slack off on their purchases and rates will soar and refinancing such maturing debt will be impossible. Being able to turn off and on their purchases with an ever shorter maturity rofile just makes those national governments ever more under the ECB’s thumb.

But it’s the other point that I think is the deal breaker. It’s that all of these purchases are to be “sterilised”. That is, they won’t lead to an expansion of the money supply. There are two problems with this:

1) The money supply is falling in the southern European countries. This is the same mistake the Fed made in the Great Depression and it’s really not something we want to repeat. But they are….

2) We’d actually like to see some inflation in the eurozone. Yes, I know, blasphemy, I should be in favour of sound money. But what we’ve really got going on is that we’ve got to get those southern economies on the track to being as efficient and productive as the northern ones. At present southern wages are out of whack with northern ones given the relative productivities. This can be solved by raising southern productivity faster than northern (a long term and difficult task) or by lowering southern wages with respect to northern.

It’s that second that has to be done in the short term and it’s a point that Keynes made which is important here. People are very unhappy indeed to see nominal wages fall. Quite apart from the problems we have when nominal wages fall but nominal debts do not. It’s much, much, easier to persuade people to accept a fall in standards of living, in real wages, if nominal wages are at least static if not rising slightly and inflation does the job of lowering real wages.

Thus, rather than price stability we’d rather have a few years, possibly even a decade (yes, the situation is that bad) of 3 or 4% inflation. If we had that, we might expect German and northern wages to rise with inflation: and southern ones to rise more slowly in nominal terms. This would mean northern real wages (with respect to productivity!) would rise relative to southern. Which is what we’re trying to get to happen.

Now I have to admit that I’m hardly unbiased here. I’m one of those who has been saying for at least 15 years that the entire idea of the euro is a very bad one. I’m against the very idea of the European Union itself, let alone my native UK’s membership of it. But even leaving all of that aside, the idea that we shouldn’t actually be here where we are at all, Draghi’s plan still isn’t a solution.

It still demands wage deflation while insisting that there should not be any inflation. And that’s just not a trick that anyone’s really successfully pulled off in a democratic society without an awful lot of social turmoil. Better by far to disguise the medicine with some inflation: which is exactly what the plan rules out.

I just don’t think it’s going to work.