Friday, March 28, 2014

Otmar Issing on Germany and the Euro Zone

by Pater Tenebrarum

A Word to the Wise

Readers may remember former BuBa board member and ECB chief economist Otmar Issing, who probably like few others personified the image of the stern, conservative German central banker (Jürgen Stark and Axel Weber were also people in this mold). Issing now and then still offers his opinion to those interested, most recently in an editorial in the FT, entitled “Get your finances in order and stop blaming Germany”.

As one might expect, Issing is no fan of 'euro-zone bonds' and similar ideas attempting to create shared responsibility for the debts of independent sovereign countries running their own fiscal policy. Several of his points are worth commenting on.

Germany Shoots Own Goal

Issing starts out by noting that Germany should best lead by example – and not by throwing money at the euro area's problems. He also reminds us that Germany's economic success is not irrevocable, and that there is a threat it won't be preserved:

“Germany is not only the biggest economy in Europe, it is also the best performing – and it would be in everyone’s interest if the country led by example. Unfortunately, it may be undermining its economic dominance by undoing past reforms and reinforcing labour market regulations. It is perhaps not too pessimistic to argue that the time will come when Germany’s economy is no longer the subject of envy.”

(emphasis added)

Ain't that the truth. The current German 'grand coalition' government has inter alia 'compromised' on the labor reform question by means of back-pedaling on the reforms which former chancellor Schröder instituted against much opposition (even in his own party) and amid popular upheaval. Schröder in the end even sacrificed his political career over these reforms. You could say they were hard-won indeed. Others reaped the gains: a few years later, Germany was no longer the 'sick man of Europe', but its 'economic locomotive'. One wonders what malady has infested the heads of today's German politicians that they believe they can once again afford to ignore the laws of economics and give away such a great economic advantage in a paroxysm of populism. Germany has fared very well by eschewing the economic nonsense of a 'minimum wage'. No longer.

Sovereign Irresponsibility and Political Union

Next, Issing tackles the question of responsibility and solidarity, and makes the point that helping others to abandon the former does not constitute the latter:

“At present, the argument for German leadership boils down to a plea that it should put more and more money on the European table. Yet the principle that there should be no bailouts is fundamental in a union of countries that share a currency but remain sovereign when it comes to public finances. A democratic European monetary union could not have been built without respecting this principle. It will be a long time before a fully fledged political union is established. Fiscal transfers will remain a matter for national parliaments.

Jointly issued eurozone bonds would violate this principle and undermine democracy. They would send a message to highly indebted countries that they can enjoy modest borrowing costs without making efforts to bring public finances under control. This would reward bad policies and punish sound economic management. Who could call this an act of solidarity?”

(emphasis added)

We agree with all the points regarding bailout policies and euro-bonds. If Germany were simply to bail out all and sundry by agreeing to euro-zone bonds, it would only rekindle the very irresponsibility that has (at least in part) brought about the crisis in the first place. Of course, Issing fails to mention that the central bank aided and abetted the formation of a giant credit credit bubble in Europe. He doesn't mention the abominable fiat money system at all. Admittedly, he hailed originally from a central bank that really did try to do the best such an institution can hope to do. But that does not alter the fact that the central planning of money is doomed to fail in the long run anyway. One only needs to consider the nonsensical 'price level targeting' policy in this context.

Still, that does not detract from the correctness of the points he makes with respect to fiscal responsibility and bailouts.

As to the assertion that “It will be a long time before a fully fledged political union is established”, one can only hope that it will never happen. As we have recently argued, we are hoping for the exact opposite. The more competition between small independent territories there is, the better it will be for the citizenry. The centralization effort of the EU needs to be stopped, the move toward the establishment of socialist super-state ruled by bureaucrats in Brussels must be reversed.

A 'political union' of Europe would be tantamount to a civilizational death sentence, as it would end all tax and regulatory competition. Instead, Europe would get what it is already getting from Brussels, only more so: the highest possible taxes for everyone, and regulation of every nook and cranny of life. Many of these regulations are already revealing the anti-civilization bias of the socialist bureaucracy (see our previous article 'Tales from the Brussels Crypt' for a few pertinent examples of the appalling nonsense EU citizens have to put up with).

Inviting Disaster via a Banking Union

Issing has a bad feeling about the rush toward a banking union, and rightly so:

“Misguided ideas also dominate discussions about a banking union. There are good arguments for creating a single supervisory authority and a unified bank resolution mechanism. But it is hard to justify forcing one country’s taxpayers to pay for the irresponsible practices of another country’s banks. What would have been the reaction of Italian or Spanish taxpayers if they had been asked to pay for the irresponsible behavior of IKB or Hypo Real Estate, German banks that had to be rescued by the state? Yet when the situation is reversed, such transfers are presented as an act of solidarity.

Legacy problems in national banking systems should be solved before banking union goes any further. If they are not, it would be better to stop the whole project.”

(emphasis added)

This is without a doubt one of the most sensible things ever uttered by a former or current high ranking EU official on the topic of the 'banking union'. Issing should however realize that 'solving the legacy problems in national banking systems' is rather difficult. These are fractionally reserved banks with a laughable 1% reserve requirement. At the height of the bubble, a mere 5.4% of all demand deposits euro area-wide actually consisted of covered money substitutes. In other words, when the crisis began, Europe's banks were collectively unable to procure almost 95% of the money they owed their customers on demand.

Things were not much different in the US of course. This is why Murray Rothbard always stressed – and one has to concur on that point – that fractionally reserved banks are in reality at all times insolvent. No other enterprise would be legally allowed to continue trading if it mismanaged its liabilities to such an extent.

However, banks in the euro area have an additional problem. The central bank can after all always intervene when bank runs threaten to drain the banks of what little of the demand cash belonging to their customers they actually hold. What it cannot do is keep the bankers from investing these funds in doomed ventures and toxic paper. As a result, they are not only unable to hew to their contractual obligations vis-a-vis a rather important class of involuntary creditors (who falsely believe their money is actually warehoused in the bank), but at the same time, many of them hold assets of highly dubious quality as well. Essentially, both sides of their balance sheets are vying with each other for the title of 'most deadly'.

It will be interesting what the ECB's coming 'bank asset quality review' reveals, but we are quite sure that many of the former concerns about the risks inherent in e.g. sovereign debt holdings have been quietly dropped by now. There are probably still enough skeletons in various closets to produce at least a handful of cosmetic complaints and admonishments. A truly rigorous examination is simply not politically palatable though. Let us also not forget that even though the debt crisis is currently in a state of hibernation, the debtbergs of the sovereigns that were at its center have continued to grow like weeds.

Euro Area TMS-a
Euro area, true money supply (currency and sight deposits). Before the crisis began, only slightly more than 5% of the extant money substitutes were covered. Today the figure is just below 10% and once again declining – click to enlarge.

euro area debt

Public debt-to-GDP ratios of EU countries as of end September 2013 (eurostat) – click to enlarge.

The Future

Issing continues by naming a few of the sinners and enumerating their sins, but it will be noticed that he is once again forgetting something important:

“The eurozone was designed as a union of sound public finances as well as stable money. Each country is responsible for its own policies. This corollary of the “no bailout” principle was a crucial element of this institutional arrangement.

The countries now in trouble have caused their own problems through their own policy mistakes. You could argue that Spain was fiscally well behaved. But its fiscal mess was the result of an uncontrolled construction boom, fueled by tax incentives, which ended in inevitable bust. Or take Italy. Who remembers its commitment in 1998 to run a primary budget surplus continuously at a level guaranteeing a decline in its ratio of debt to gross domestic product? When Italian interest rates fell to German levels as a result of monetary union, it reaped a dividend of tens of billions of euros. These savings were wasted. Increasingly, Germany is blamed for Italy’s miserable situation. Italian entrepreneurs can tell you where responsibility really lies.”

(emphasis added)

We don't doubt that Italy's politicians wasted the savings the government enjoyed due to declining interest rates. We also don't doubt that there were skewed incentives at work in Spain that egged the housing bubble on. But Issing once again skirts the question of the central bank aiding and abetting the bubble excesses.

As to 'stable' money, we don't even know anymore what this is supposed to mean. According to current central banking orthodoxy, a money is 'stable' if the mythical 'general level of prices' (which doesn't exist and cannot be measured) rises by 2% per year. That is simply an absurd theory. No wonder we are lurching from one bubble and bust to the next. Again, it must be remembered though that the German BuBa was indeed highly responsible for an institution that is confronted with a special case of the socialist calculation problem. Issing's worldview is undoubtedly informed by this fact.

Issing concludes:

The future of the eurozone – and that of Germany – will rest on sound economics. As well as stable money and solid public finances, that means competition, flexible labor markets and sustainable pension systems. This was the philosophy on which Europe’s monetary union was built.

Walter Hallstein, the first president of the European Commission, stressed repeatedly that the EU was based on the principle of law. Credibility in the eurozone can be restored only if treaties and rules are respected again. Those who violate rules should face sanctions. Those who wilfully continue to violate the rules should not be allowed to blackmail the others – and should consider leaving. The eurozone did not fall into a crisis because the initial rules were flawed – but because countries have constantly violated its rules.”

(emphasis added)

One cannot disagree with the notion that sound economics should be pursued and that competition, flexible labor markets and sustainable pension systems must be part of the package. However, the hope that the 'treaties and rules will be respected again' and the underlying idea that it was not the 'rules that were flawed', but that the problem lay in their implementation, misses that there is indeed a flaw in the system. Such as it was set up, it rewarded irresponsibility, and likely continues to reward it, because a kind of 'tragedy of the commons' situation has been created. Countries violated the rules precisely because it appeared from the outset as if that could be done without having to fear consequences.


We obviously agree with Mr. Issing on a great many things. However, his critique is incomplete and does not go far enough. Still, one can probably not expect much more from an establishment figure. Since Issing was himself a central banker, he avoids a critical examination of this particular institution. And yet, the crisis of the euro area cannot be fully grasped without it.

PS: we have been asked by readers to comment on the recent 'Weidmann U-turn' regarding a possible ECB version of 'QE'. We simply didn't get around to writing about the topic yet, but will do so soon.


Otmar Issing, former BuBa board member and ECB chief economist.

(Photo via DPA / Author unknown)

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