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The probability of a Eurozone break-up

European Central Bank President Mario Draghi (C)

By Stelios Papadopoulos

ON March 6, the European Central Bank decided to keep the refinancing rate – the interest rate paid by the banks when they borrow money from the ECB – at 0.25% despite forecasts of low inflation. The ECB based its decision on expectations of slow increases in inflation over the next three years as well as anticipations of higher economic output compared to its December forecasts. But according to Reuters, there was near unanimity among ECB policymakers that it would either begin its own version of Quantitative Easing – where the ECB would buy up government bonds and other securities from the markets – or end its so called “sterilisation” programme, where the bank offsets the money it puts into the system through the purchase of government bonds by withdrawing an equivalent amount, in an effort to increase liquidity in the system and prevent the advent of deflation.

Deflation refers to the generalised negative change in the level of prices. Once it sets in it leads to a phenomenon called debt deflation which, if not checked through fiscal or monetary policy, the effects for the economy will be certainly dire.

Debt deflation refers to the causal interdependencies between debt, deflation and default. Under this process, a generalised fall in prices triggers the sale of financial and real assets in order to pay off debts. But the sale of these assets leads to a further fall in the prices of goods which reduces profits and leads to job losses. These in turn reduce wages and demand leading to a further fall in prices.

Yet, despite the fact that wages and profits fall, debt payments do not decline, a fact which increases real debt levels and hence defaults leading to a rise in non-performing loans which threatens the integrity of the banking system. In the context of the Eurozone, deflation would also be a big problem for the heavily indebted peripheral states which would see their borrowing costs increase and their tax revenues reduced.

Anyone who has followed the financial press is aware of the fact that there is agreement among analysts and investors that when deflation sets in the ECB will, in fact, initiate its own QE programme to avert a catastrophic banking crisis which would threaten the viability of the Eurozone.

According to Nouriel Roubini, the economist who predicted the 2008 crisis, either Germany accepts a fiscal union, debt mutualisation and a fiscal stimulus and higher wages or QE.

Given that Germany has, since the beginning of the crisis, rejected the former for political reasons it is not hard to see that the only sensible option politically and economically is a QE programme.

Roubini adds that although there is opposition within a section of the German elite as typified by Jens Weidmann of the Bundesbank, such opposition has until now been marginalised as evidenced by the introduction of OMT – where the ECB can, if necessary, buy directly the bonds of specific countries – and cuts in the refinancing rate despite opposition from the Bundesbank.

However, Roubini’s argument misses one thing. First of all, Germany is against the establishment of a banking union. By that I mean a system whereby the ECB has the ability to directly recapitalise the banks of a Eurozone state – the ability, in other words, to buy government bonds and other assets from bank balance sheets – and that is because a banking union transfers control over Germany’s bond markets from Berlin to the ECB. QE would amount to the same thing.

If Germany opposes a banking union, why would it be in favour of QE? Necessity (ie. deflation) would force it to accept the measure, one might say. But if they did not accept a banking union back in 2010-2012 when the Eurozone was in a deep state of crisis, why would they accept QE when deflation begins to set in?

One way would be to end the “sterilisation” programme but Draghi himself pointed out that this would not be sufficient and the fact that Weidmann is in favour of it is enough to show that it will not work. The Bundesbank’s president belongs to that section of the German elite who want a return to the Deutschmark. A Reuters poll of economists found that another wave of cheap cash through long term loans is the most likely scenario. I believe this is correct, otherwise the ECB would not have left interest rates unchanged. They want to use every other option before considering a QE programme.

But if cheap cash does not do the job it is doubtful whether QE would be used as a last resort. On the other hand, when the time comes we will see whether preserving the Euro is in fact a priority for Germany.

Stelios Papadopoulos, MSc Political Economy, is a political risk analyst

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