Apparently, the ECB felt that the Euro patient was by then well enough to cope without the ECB but, within days, the Euro Zone commercial banks, which had previously been crowding into the Greek yield curve (and in so doing had allowed the Greeks to finance a burgeoning budget deficit), began to exit their positions as they feared a potential rise in their own funding costs.  Within weeks, this exit from the Greek debt markets had turned into a rout.  Within months, this had accelerated to become the PIIGS (Portugal, Ireland, Italy, Spain) crises.  Now, 24 months later and following countless Euro Zone summits, the crisis continues unabated and, in many respects, it has become notably worse rather than better.  Rather than recovering his health, the Euro Zone patient is now firmly on the critical list.

The basic problem within the Euro remains the fact that there is a wide competitiveness differential between the core countries and the periphery.  This situation is not new; in the early days of the Euro a similar differential existed between the core and the periphery but the other way around, in that the core was uncompetitive but the periphery competitive.  This differential was ultimately solved, not by Germany deflating (it is an urban myth that this occurred) but by the periphery inflating, in part under the influence of huge capital inflows from the cores (the Euro Bubble theme of the late 1990s which favoured Ireland, Spain et al).  Germany regained its competitiveness not through its own deflation but rather through inflation in its Euro partners but unfortunately the latter continued to the point at which the periphery became hugely uncompetitive.

One might argue that Germany should now agree to suffer a depreciation of the Euro and an increase in its own inflation to ‘repay the favour’, thereby allowing its neighbours to regain some of their former competitiveness. However, its political and demographic structures, coupled with the capital adequacy problems in its banks, have ensured that Germany has not inflated and to all intents and purposes, the Euro has not fallen on the foreign exchanges.  Moreover, judging by the latest data this situation is unlikely to change in the medium term and hence, the onus of adjustment has been placed firmly on the periphery, which is being asked to deflate on a scale not witnessed since Asia in the late 1990s Crisis.

At one level, we can suggest that the fiscal austerity regimes and the fact that Spain, Greece and Italy are suffering depression-style contractions in their economies at present is proof that they are attempting to adjust.  However, this adjustment is proving hugely painful as unemployment – and particularly youth unemployment soars.  Indeed, Italy’s (albeit unelected) prime minister recently voiced concern that Italy’s predicament was threatening to make the country ungovernable and that to continue along this path risked giving populist fringe political parties that would leave the euro a greater say in running the country.  At an economic level, the countries might finally be moving towards the deflation that the system requires in order to regain its equilibrium but the social and political costs are immense and perhaps untenable – the euro has already shown itself to be an incumbent government killer and by doing so it risks sowing the seeds of its own political destruction.  In fact, we believe that if the ECB continues on its present course and Germany does not inflate or the euro currency weaken, then the Euro will fracture within the next three years.  Crucially, this notion seems to be becoming a more common view within the Euro itself.

In fact, as Greek and other residents of Europe’s embattled periphery have increasingly come to fear a possible breakup of the Euro, they have begun to view holding bank deposits in their own banks as a reward-less risk.  Hence, huge deposit flight has begun and the situation in the regions’ banking systems has become ever more precarious as a result. 

Specifically, if you as a Greek resident fear a probable dissolution of the Euro, then you would notionally want to borrow Greek versions of the Euro but at the same time hoard German versions of the Euro.  Hence we have seen (until recently) positive credit growth in Greece but negative deposit growth in the local banking system.   As a result, the volume of Greek private sector credit has increased by 27% since the PIIGS crisis first began but the volume of bank deposits has over the same period declined by almost a third.  Consequently, the Greek private sector debt burden has risen by almost a quarter since people first noted that it was too high and the banks’ loan to deposit ratio has also moved up dangerously.  We also find that as Greece’s economy has contracted, the budget deficit problem has proved predictably intractable with the result that public sector debt is now 20% higher than when the crisis first became noticed.  Hence, Greece’s debt predicament is worsening exponentially even as they try to do what is being asked of them.

Greece is, of course, an extreme example but the same type of arithmetic can be found in Ireland, Spain, Portugal, Italy and increasingly France, in which the banks have become dependent on ECB-sponsored financing (through the alphabet soup of rescue funds such as LTROs and, in particular, a system known as TARGET2 that obliges the German central bank to implicitly lend huge sums to the weaker countries).  Meanwhile, the German commercial banks have seen their loan to deposit ratios drop below 80% as deposits have piled up in their vaults but domestic loan demand has remained moribund. 

This may sound technical, but the widening divergence between the loan / deposit ratios in the core and the periphery is an important monetary manifestation of the serious competitiveness and balance of payments disequilibria that now exist within the Euro, as Germany amasses large surpluses (and hence its central bank is the one which is obliged to lend huge sums through TARGET back to the weaker states) but the periphery – including France – suffer large deficits and a consequent increase in their levels of indebtedness to the core, again, via the TARGET mechanism.  Perhaps the best way to think of TARGET is as a piece of wallpaper that is being hung over a particularly troublesome and ever-widening crack in the wall – it covers the damage but does not solve it.

Indeed, the fact that the ECB / EU’s policy responses to the crises have brought no improvement in underlying bank solvency or in any of the Euro’s other key flaws (such as the lack of a single sovereign state to guarantee it and the competitiveness differentials that we note above and of course the Region’s apparent inability to grow) is a damning indictment of the authorities’ potentially fatal failure to grasp the gravity of the situation.  

As to the whether the break up occurs sooner (which would be highly disorderly) or later (more orderly) is a more difficult question to answer.  In theory, if the German state sector is prepared to continue lending to its partners in what we have suggested is an almost clandestine way through the TARGET system, then the unsustainable situation in the Euro can presumably be sustained a while longer, albeit at the cost of a further deterioration in the underlying health of the banking systems and the finances of the German state. Germany is building huge contingent liabilities when it implicitly underwrites loans to the rest of the union.  In effect, the German wallpaper would be obliged to become ever wider to hide the cracks. 

What we do know at a practical level is that markets are latching on to the existence of the once obscure TARGET system. Various blogs and the newspapers are finally carrying the story with more frequency and this does raise the prospect of German political opposition mounting to the Bundesbank’s role as lender of first and last resort within TARGET and therefore becoming a destabilizing factor for markets.  Although the Europhiles would presumably retort at this point that the Bundesbank is notionally obliged by various treaties to keep lending via TARGET, come what may.

However, at a practical level, we wonder if this assumed lack of Bundesbank discretion over TARGET is really the case.  We do find it very interesting that when pro-Europe Axel Weber was Bundesbank President between 2004 and April 2011, this was the period in which the TARGET balances expanded dramatically.  However, when he stepped down (officially in April 2011), we found that under its new President and the “hard money” ECB economist Stark, the Bundesbank’s TARGET exposure suddenly leveled off (implying that it was no longer lending to the periphery) and the peripheral economies each then began to behave in the way in which one would have expected them to if their countries were facing a balance of payments crisis within the confines of a fixed exchange rate regime. That is, real interest rates soared, asset prices declined and the economies slumped.  However, once Stark also resigned in September 2011 (for ill-defined personal reasons), the Bundesbank began lending via TARGET to the periphery once again and the Euro Crisis has appeared to ease once again.

At the very least, the experience of the peripheral countries over the summer of 2011 at a time in which the Bundesbank seemed to become strangely inactive within the TARGET system shows the potential for the Euro Crisis to worsen and perhaps break the system if TARGET were to fail to continue expanding.  More intriguingly, we also wonder whether the mid 2011 episode also shows that, at a practical level at least, Buba (the German Bundesbank) does have some discretion when it comes to its involvement in TARGET. 

At present, we have no doubt that German Chancellor Angela Merkel and others will be pushing Buba to be fully involved, but if domestic German politics were to turn against the Bundesbank’s ever expanding involvement in funding Europe’s weaker states through the TARGET system, then we would then have to wonder if Germany might finally call an end to a project that is now causing economic misery to millions. 
In the long term, we believe that the Euro is doomed as anything other than a weak currency in which policy is set according to the needs of the weakest states.  Whether the Euro survives through 2012 however will depend on whether the Bundesbank chooses to, or is even allowed to, continue expanding its TARGET exposure.   We therefore advocate the monitoring of the news flow in Germany on the subject of TARGET, since this is the Euro’s Achilles’ Heel.  If TARGET fails, then the runs on the banks will become ever more extreme and from there we suspect that it would be a short step to the complete breakup of the Euro.

Andrew Hunt is the head of Andrew Hunt Economics and a consultant to van Eyk

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