Marshall Auerback, who is working for more than25 years as an investment manager, is serving as a global portfolio strategistfor RAB Capital Plc, a UK-based fund management group. He is also co-manager ofthe RAB Gold Fund and an independent economic consultant for PIMCO, the world’slargest bond fund management group. Further, he is a fellow of the Economistsfor Peace & Security (www.epsusa.org) and of the Japan Policy Research Institute in California (www.jpri.org). As Braintruster of the Franklin and Eleanor RooseveltInstitute, he is afrequent commentator at “New Deal 2.0” (www.newdeal20.org).In this exclusive interview for MMNews he talks about the euro zone.

Mr.Auerback, you see profound problems coming to the euro zone.

Well, I think the euro zone is areally big problem. I've said this before, but in here it is again:

"Governmentspending is financed through the issue of currency, taxes generate demand forthat currency that results in sales to government, bond sales merely substitutebonds for cash, and central bank operations determine interest rates anddefensively add or subtract reserves. The relation of member countries to theEuropean Monetary Union (EMU) is more similar to the relation of the treasuriesof member states of the UnitedStates to the Fed than it is of the USTreasury to the Fed. In the US, states have no power to create currency; inthis circumstance, taxes really do 'finance' state spending and states reallydo have to borrow (sell bonds to the markets) in order to spend in excess oftax receipts. Purchasers of state bonds do worry about the creditworthiness ofstates, and the ability of American states to run deficits depends at least inpart on the perception of creditworthiness. While it is certainly true that anindividual state can always fall back on US government help when required(although the recent experience of California makes that assumption lesssecure), it is not so clear that the individual countries in the euro zone areas fortunate. Functionally, each nation state operates the way individualAmerican states do, but with ONLY individual state treasuries."[i]

Consequently, the euro dilemma is somewhat akin tothe Latin American dilemma, such as countries like Argentina regularly experienced.Deficit spending in effect requires borrowing in a ‘foreign currency’,according to the dictates of private markets and the nation states areexternally constrained. That's why Icelandand Latviaare in a mess and suffer from solvency issues. It's also why Californiasuffers from a solvency issue or Italyor Spain.Not the US or Japan. Greece issimply the soft underbelly of the euro zone.  If Greece goes,they all start to go.

What areyour expectations for Greece?

As far as Greece goes, in the firstinstance, the sanctions available (if any) to punish Greece for spending morethan the EU or ECB would like is via the Stability and Growth Pact (SGP), whichas you know are imposed as fines by ECOFIN for violations of deficitlimits

Operationally, the Greek Treasurywrites its checks on Greek banks. When it does so, it creates euro.  

Does anyoperational constraint limit the capacity of the Greek government to create euroin this way? Or is the only constraint the self-imposed one of the SGP?

Well, for one thing, it has to haveeuro in its bank account at the Greek bank, unless the Greek bank wants to loanits euro. Perhaps the Greek government spend without going to the bondmarket, but it can't create currency. It can borrow from the banks, but that'uses up' bank capital and balance sheet, and adds risk to that bank,etc. 

During a period of euro weaknessfunding problems could become worse and spread to other euro nations.

When foreign governments buy eurosfor their portfolio of foreign exchange reserves, they have to hold themin some kind of account or security.  Most probably option for theeuro zone is national government paper. Same with internationalinstitutional investors. When they stop adding to their euro portfolios and/orreduce them, they stop buying and/or sell that paper.

The new holders of euro (those whobuy the euros when portfolios sell them) may or may not buy that same governmentpaper, and the euros may instead wind up as excess reserves at theECB in a member bank account, or even as cash in circulation asindividuals who don't trust the banks turn to actual cash. The banks withthe excess reserves may or may not buy the National government paper or evenaccept it as repo collateral, to keep their risk down, and instead simplyhold excess reserves at the ECB.  

Markets will clear via everwidening funding spreads as national government paper competes for euros thatare otherwise held as 'cash reserves.'  The amount of reserves heldat the ECB doesn't actually change, apart from some going to actualcash.  What changes are the 'indifference levels'-yield spreads-betweenhaving cash on your books and holding national government paper risk. Andthe ability to repo national government paper at the ECB doesn't helpmuch. 

Would you buy Greek paper today ifyou were concerned it might default just because you could repo it at the ECB,for example?        

Additionally, while Americans go to insuredbanks and Tsy secs when they get scared, Europeans exit the currency asthey have a lot more history of hyper inflation.  

That means a non virtuouscycle can set in with a falling euro making Nationalgovernment funding problematic, which makes the euro continue to fall.   

Didn’thappen this already before? And what is the difference now?

Yes, this happened a little over ayear ago due to a dollar funding liquidity squeeze. The Fed bailed them outwith unlimited dollar swap lines and the euro bottomed at something less than130 to the dollar. This time it's not about dollars so the Fed can't help evenif it wanted to.

And the 'remedies' of tax hikesand/or spending cuts Greece intends to pursue will only make it all worse,especially if undertaken by the rest of the euro zone as well. Fiscaltightening will only slow the economy and cause national governmentrevenues to fall further, unless the taxes are on those taxpayers who will notreduce their spending (no marginal propensity to spend) and the spending cutsdon't reduce the spending of those who were receiving thosefunds.  And the treaty prevents ECB bailouts of the Nationalgovernments so any bailout from the ECB would require a unified Fin Min actionand an abrupt ideological reversal of the core monetary values of theunion towards a central fiscal authority.   

This is somewhat analogousto what happened to the USwhen the original articles of confederation gave way to thecurrent constitution in the late 1700's.

I have suggested a solution whichcould work here, but I doubt the ECB will buy it.

Here it is:

DEFICIT TERRORISMCOULD KILL THE EURO[ii]

By Marshall Auerback

On more than a few occasions, we have discussedthe insanity of self-imposed political constraints which limit the range offiscal policy. As well as imparting a deflationary bias to an economy (andthereby preventing full employment), these kinds of constraints preclude theadoption of prompt counter-cyclical policy, which would otherwise cushion aneconomy when confronted with a genuine financial crisis, as we are experiencingtoday.

The constraints under which the US operates aremore apparent than real.  As we havediscussed before, these constraints are largely based on 19^thcentury gold standard concepts, which have no applicability in a fiat currencyworld. Tomorrow, if the USwanted to run a budget deficit equivalent to 20 per cent of GDP, it could doso, politics and demagoguery aside. 

Suchis clearly not the case in the euro zone, where countries, such as Spain, thathave 20 per cent unemployment are being forced into further belt tightening.And the news just keeps getting worse: Expansion in Europe’s service and manufacturing industriesunexpectedly slowed in January, adding to signs the pace of the economy’srecovery may weaken.

A composite index based on a survey of purchasing managers in bothindustries in the 16-nation euro region fell to 53.6 from 54.2 in December,London-based Markit Economics said today in an initial estimate. Economistsexpected an increase to 54.4, according to the median of 15 estimates in a Bloombergsurvey. A reading above 50 indicates expansion.

The euro-region economy may lose momentum as the effect of governmentstimulus measures tapers off and rising unemployment erodes consumers’willingness to spend. More significantly, the very viability of the currency is now beingcalled into question even within the councils of the European Monetary Union(EMU), where fears of a euro breakup have reached thepoint where the European Central Bank (ECB) itself feels compelled to issue alegal analysis of what would happen if a country tried to leave monetary union(http://www.telegraph.co.uk ).

A currency vaporizing before our very eyes!  All for what? Some misguided anti-inflation fear? A desire to maintain the euro as a“store of value”?  What’s the point ofhaving a “store of value” in your pocket when you don’t have enough of it tobuy anything because you’re unemployed?

We have long viewed the principles underlying Europe’s monetary union as profoundly misconceived.  In particular, the so-called Stability andGrowth Pact is economically flawed and politically illegitimate, given thepower of unelected bureaucrats within the euro zone to ride roughshod over theclearly expressed preferences of national electorates.  A law that governs economic decisions yet iseconomically illiterate cannot stand for long. It merely invites non-compliance and worse, as we are witnessingtoday.  And the problem is not restrictedto the so-called “PIIGS” countries (Portugal,Ireland, Italy, Greeceand Spain).  The larger – and wealthier – Europeaneconomies however have never reduced their unemployment rates below 6 per centand the average for the EMU since inception is 8.5 per cent (as at July 2009)and rising since. The average for the EMU nations from July 1990 to December1998 (earliest MEI data for the EMU block available) was 9.7 per cent but thatincluded the very drawn out 1991 recession. Underemployment throughout the EMUarea is also rising (http://bilbo.economicoutlook.net), reaching 20% in Spain and double digits in Portugal, Italy,Ireland, and Greece.

Until now, the Eurocrats have either remainedin denial about the mounting stress fractures within the system, or forcedweaker countries to impose even greater fiscal austerity on their sufferingpopulations, which has exacerbated the problems further.  And there has been a complete lack ofconsistency of principle.  When largercountries such as Germanyand France routinelyviolated spending limits a few years ago, this was conveniently ignored (orpapered over), in contrast to the vituperative criticism now being hurled at Greece.   The EU’s repeated tendency to make ad hocimprovisations of EMU’s treaty provisions, rather than engaging in the hard jobof reforming its flawed arrangements, are a function of a silly ideology whichis neither grounded in political reality, nor economic logic.  As a result, a political firestorm, whichcompletely undermines the euro’s credibility, is potentially in the offing.

Sowhat are the alternatives?  Exit from thecurrency union would be the most logical, but also potentially the mosteconomically and politically disruptive. As Professor Bill Mitchell notes, to exit the EMU a nation and regaincurrency sovereignty, the following changes would occur:

• The nation would have to introduce a new/old currency unit under monopoly issue. Within this currency the national government could purchase anything that was for sale in that currency including domestic unemployed labour.
• The central bank of the nation would receive a refund of the capital it contributed to the ECB.
• The central bank would also get all the foreign currency reserves that it moved over into the EMU system.
• The nation’s central bank would then regain control of monetary policy which means it could set the interest rates along the yield curve and also add to bank reserves if needed.

(http://bilbo.economicoutlook.net )

Thereis clearly the additional problem of debt which is now denominated in euros,because, as Mitchell notes, the problem because the nation that wanted to exitwould have to deal with a foreign currency debt burden, and might find itselfinvolved in a painful adjustment process in which the departing nation isforced to experience a punitive negotiated settlement (unless of course it wasable to engineer payment in the new local currency).

Personally,we think the whole euro zone system is an abomination and would prefer to seeall euro zone states go back to national currencies and thereby get theirrespective economies back on track with renewed fiscal capacity. But there isalso a short term expedient which might prove minimally disruptive to the EuropeanMonetary Union’s current political and institutional arrangements, but couldwell succeed in restoring growth and employment in the euro zone.

Within the euro zone, short ofleaving, the most elegant adjustment mechanism is for the ECB todistribute 1 trillion euro to the national governments on a per capita basis.This proposal would operate along the lines of the revenue sharing proposals werecently advocated for the American states. The nation states of the euro zonewould the instructions from European Council of Finance Minister (ECOFIN) andthe ECB would then change the balances in all of the national member bankaccounts, in effect increasing their assets, and thereby reducing debt as apercentage of GDP. 

Within the euro zone, this sort ofa proposal would likely give the respective EMU nations more bang for theirrespective euros, given the more elaborate social welfare programs in the EU.There would be less pressure to "reform" them (i.e., cut them back)if the EU nation states debt ratios are correspondingly lower and"compliant" within the bounds of the SGP.

The per capita criteria deployedhere means that we are neither discussing a bailout per se of one individualcountry, and nor a 'reward for bad behavior.'  All countries would receivefunds from the ECB on a per capita basis, which means that Germany wouldin fact become the biggest beneficiary. The fact that all countries are in the euro zone means there's nopossibility of Germany losing competitive ground to Spain or other low wagecountries.  It would immediately adjustnational govt. debt ratios substantially downward and ease credit fears. 

If there is no undesired effect onaggregate demand/inflation/etc., which there should not be given the prevailinghigh levels of unemployment in the euro zone, it can be repeated as desireduntil national government finances are enhanced to the point where theycan all take local action to support aggregate demand as desired.  

The proposal advanced is the mostinstitutionally elegant solution because it maintains the current arrangements,as flawed as they are, and preserves the euro.  Yes, a weaker euro wouldalmost certainly result from this action. However, as "nationalsolvency" is an issue for the euro countries (in a way that it is not forthe US or Japan or the UK, given that the euro zone nation states arefunctionally more like American states than independent countries with theirown freely floating non-convertible currencies), the resultant higher exportgrowth that comes from a weaker euro is actually benign for everybody, as itminimizes the markets' solvency concerns. 

The formation of the European Unionhas been largely driven bythe extremism of inter-European conflicts that caused millions of people to beslaughtered during two disastrous world wars. Ironically, the political andeconomic arrangements that have arisen in response to these horrors arecreating a different kind of social devastation which is both whollyself-inflicted and profoundly misconceived.  Europe’s very currency could well blowup.  The US might well preserve itscurrency, but the EU’s current situation provides a salutary warning of whatcan happen  in a system that preventsindividual member’s from using fiscal policy to improve the circumstances of theircitizens.