Why we need the European Central Bank as Lender and Owner of Last Resort

12. Dezember 2011 Von 70 Kommentare

A guest post by Arash Molavi Vasséi

This post summarizes a short policy note in which I argue that the only feasible as well as incentive-compatible solution to the current sovereign debt crisis in the Eurozone involves the European Central Bank (ECB)

  • as a Lender of Last Resort to the Eurozone’s core countries like France, Austria, Finland, and The Netherlands, and
  • as the Owner of Last Resort to the European banking system, thereby setting the stage for haircuts on the debt of potentially insolvent peripheral Member States like Greece, Italy, Spain, and Portugal.

The arguments for a credible commitment of the ECB to an unlimited swap line, promising to swap central bank liabilities for sovereign bonds with the aim to reduce liquidity premia, are well-known. So I won’t repeat them here. I will rather focus on the second part of my argument, on the ECB as an Owner of Last Resort. As far as I am aware of, the idea is new. I guess the idea is fundamentally flawed in a way that I cannot see. To cite Kantoos: “do poke holes into this proposal, as I am really interested in whether it could work”. Note, however, that I am full aware that the implementation of the idea is neither politically feasible, not is it legal (see the conclusion). My arguments are just concerned with economic admissibility.

The ECB as Owner of Last Resort

There are few economist who would deny that a haircut on sovereign debt is an incentive-compatible solution; the extremely serious downside is the risk of a breakdown of the European banking sector and global contagion.

But it seems possible to contain the risk of bankruptcy and contagion. In a first step, the European Banking Authority (EBA) should come up with serious stress tests, that is, with projections free of any political considerations, predicting the impact of realistic haircuts on peripheral sovereign debt as well as the impact of a Europe-wide recession on each Systemically Important Financial Institution (SIFI) in Europe. The most recent stress test may give a picture of the minimum level of recapitalization needs (114.7 billion overall; I expect a multiple). Next, the ECB should step in as the Owner of Last Resort and recapitalize each such SIFI according to the EBA’s projections. In contrast to its role as Lender of Last Resort, the ECB would swap central bank liabilities for preferred stocks, i.e., senior equity securities that carry no voting rights and, thus, prohibits the ECB from getting involved in the SIFI’s business models.

There are clear advantages of the ECB engaging as the Owner of Last Resort:

1. The most important reason why the ECB should engage in the recapitalization of the European banking sector is the same as usual: it can create unlimited amounts of central bank liabilities and, thus, unlimited amounts of premium-quality capital. The ECB as an Owner of Last Resort thereby avoids the vicious circle that any other realistic recapitaliization scheme would trigger: if Member States like France and Germany are supposed to finance heavy haircuts on peripheral sovereign debt, their own solvency could be endangered, respectively; this would suggest even higher default probabilities and potentially higher haircuts on sovereign debt. In turn, Member States would have to get involved in a second recapitalization-scheme, which would endanger their solvency and credit ratings even further; the feedback loop would continue until the entire Eurozone eventually collapses.

The same is true for any other limited fund like the EFSF, which is eventually backed by France and Germany (IMF-financed recapitalization would in addition endanger U.S. ratings; neither the Obama administration, nor the Republican presidential candidates show any interest in increasing IMF-funds; also China refuses to support the EFSF). By contrast, the ECB cannot become insolvent. That such a situation is considered in its constitutions is only due to the fact that it is designed by lawyers, obviously unaware of the basics of central banking: what makes a central bank so special is that the unit of account in a at system is defined in terms of its liabilities, and that its liabilities are used to redeem contracts. The monopoly producer of the means of final settlement just cannot get bankrupt, for bankruptcy happens if you lack the means to settle your obligations. Unconstrained by its constitution, any central bank can shield its equity capital against losses. All it needs to do is some creative accounting: it could invent an asset class, call them “claims to Europe’s future”, and neutralize any risk to its balance sheet.

2. The approach is incentive-compatible: it rescues banks, but punishes their owners. Given the increased quantity of SIFI-stocks, the share of profits generated by such financial entities that could be distributed to the private sector diminishes. In short, recapitalization is a blow to the return on capital invested, reducing the value of each stock in circulation as well as the value of newly issued stocks. This is why banks hate it, and why they negotiate insufficient haircuts. Thus, recapitalization by the ECB must be mandatory to avoid resistance by the SIFI’s managements – who are obliged by law to protect the interests of private shareholders.

3. The approach avoids deleveraging processes that otherwise will accompany the revision of the the EU’s Capital Requirement Directive (CRD IV), which implements Basel III (in fact, CRD IV goes beyond Basel III). By selling risky assets (like peripheral sovereign bonds) and cutting well-established credit lines to potentially profitable companies, banks increase their capital ratio, respectively, by reducing the denominator. By contrast, the ECB as Owner of Last Resort would increase the numerator, leaving no rationale to deleverage. This ensures that (1) bank lending to the so-called “real economy” and (2) the transmission mechanisms of monetary policy remain intact.

4. Finally, and closely related to point 3, the ECB as Owner of Last Resort would back the possibility to implement significantly higher capital requirement over a horizon of ten to fifteen years. Research shows that high capital requirements are not detrimental to economic growth (Admati et al.). Instead, they ensure that systemically relevant institutions climb down the  “Efficient Frontier” such that a lower return on capital invested is compensated by reduced risk.

Ask yourself: Of all possible investments possibilities, why should systemically relevant institutions be the hotbed of relatively less risk averse or even risk-loving investors? All it needs is that the ECB injects more capital than projected by the EBA such as to ensure capital ratios around twenty or even thirty percent. In the aftermath of the crisis, the ECB would sell its preferred stocks during a period of ten to fifteen years, while commercial banks are prohibited to buy back these papers.

Conclusions

Liquidity distress – also due to policy uncertainty – seems to be an appropriate explanation of the spreads on the debt of the Eurozone’s core (see the paper for more). To contain the crisis, the ECB should act as a Lender of Last Resort, that is, it should credibly commit itself to an unlimited swap line as described above. However, to resolve the crisis the ECB should also act as an Owner of Last Resort with respect to the European banking sector and, thereby, set the stage for haircuts on the debt of potentially insolvent peripheral members of the Eurozone.

Of course, there is little hope that Germany will ever support such unconventional measures. It already brought France and Italy into line: they all announced not to seek for ECB intervention to rescue the Eurozone from a deepening sovereign debt crisis. But the problems with my proposal root deeper: it seems not only politically infeasible, but is clearly illegal. As an adherent to the rule of Law, I feel highly uncomfortable with my own suggestions. Yet, I am not aware of an economically admissible solution to the sovereign debt crisis in the Eurozone that also conforms to law, including those measures am opposed to. Given that the current legal framework does not support any feasible solution, and given that we do not have the time to adjust the legal framework, we will break the law anyway. Actually, we broke it already.

So this may be the major lesson of the political project to impose a common currency on a non-optimal currency area: any attempt to implement a political vision in contradiction to economic regularities (some may say in contradiction to “economics laws”) is not only doomed to fail, but also undermines the fundamental ingredient to a free and prosperous society: the Rule of Law.

Filed Under: Finanzmarkt, Makro Tagged With: , , , , , , , , , , , , , ,

Decoding Euro-moralizations

5. Dezember 2011 Von 100 Kommentare

Moralizations of the extreme form, Italian edition

There are some moral debates about the Euro going on in the international blogosphere with Tyler Cowen and Ryan Avent as the main participants, and Scott Sumner adding some interesting historical perspective.  In my view, Ryan and Tyler are not talking about the same thing, so let me offer a different take on the issue.

In discussions of the Euro crisis, all sides occasionally end up in a moralizing grey area, and this blogger is no exception (sorry for that). But I think we need to distinguish two different layers of moralizations.

The first is a sort of good/bad ideology, in which either A) the lazy, profligate Southeners get what they deserve and hard-working, prudent Germany is right to refrain from costly help, or B) the Southeners are the victims of an easy-to-fix debt run, but the selfish stability-fetishists in Germany rather hurt millions of Greeks and Italians than to embrace the obvious solution after they have so tremendously benefited from the Euro.

This sort of moralizing should be avoided by anyone who is interested in a serious discussion of the Euro crisis.

The second is the one Tyler is describing,

the kind of “system-wide” moral judgments that progressives offer up when they judge the institutions of Denmark to be superior to the institutions of Mexico, of course without ever judging the residing individuals per se.

He offers 11 examples of this kind of moralizing from a German perspective. The deeper reasons for such moralizing behaviour is, I think, a sense that something is going wrong in Europe without the ability to analyse it in economic terms, terms of game theory or political economics. Such moralizations are usually derived from principles, things you should or shouldn’t do, principles that were embedded in society for a reason: if you don’t have the ability to grasp the whole situation, it is best to stick with agreed-upon societal behaviours that served you well in the past. These may be principles of fairness, solidarity, responsibility, pragmatism, forgiveness, stability, loyalty, lawfulness and many more. Different societies put their emphasis on different subsets of these, and as Scott correctly notes: whether that choice is good or not is context-specific.

Although they are not very helpful, I would not dismiss this second kind of moralizations as easily as the one above. Sure, the distinction between the two is blurry, but there is some justified discomfort and scepticism expressed in such moralizations that actually have a serious representation in economic terms. I let Tyler describe part of it from a German perspective:

Do not think that Germany has merely to waive a magic wand, or incur a one-time cost, to set things right in the eurozone.  Any “set things right” action on Germany’s part is, one way or another, a form of doubling down.  If it fails it means a bigger eurozone implosion in the future than would happen now, including much higher costs for Germany.  The choice is not “German action vs. doom now,” it is “German action and some chance of even bigger doom later on vs. doom now.”  That’s a tough call.  The Germans understand that one better than do most of the bloggers I’ve been reading on the topic.

Moralizations of the extreme form, German edition

Of course, there are justified economic concerns behind opposite moralizations of this second kind as well. For instance, complains that Germany is unsolidarily forcing countries into depression. This moralizing statement just reflects three very important issues that tend to be ignored or dismissed much too easily in Germany:

  • Short term austerity makes things worse if there is no national central bank to pick up the slack. Almost any macroeconomic model tells us that, not to mention the empirics.
  • Deflation – if resulting from a decline in aggregate demand – is an economic catastrophe. The Germans should know that better than any other country in the world, but surprisingly most don’t. Insisting on low inflation at a time of massive economic adjustments in a currency union is inflicting enormous suffering on the periphery.
  • Central banks need to be an aggressive lender of last resort to banks to avoid a financial collapse. That is not an unorthodox Anglo-American money-printing idea. It is one of the main reasons why central banks were founded in the first place. A lender of last resort to sovereigns is a more complex issue in a currency union without a unified fiscal policy, as almost any proponent would admit.

Contrary to Ryan, I think it is useful to deal with moralizations of the second type head-on and try to explain to both sides what the economics behind these moralizations are and discuss whether they are justified or not. I find that it works well with family and friends in Germany.

But the worst thing we can do as bloggers is to get into the grey area around both kinds of moralizations ourselves – if only by playing a simplistic blame game. We should know better, and we are capable of expressing what we mean in economic terms. But the issue is subtle, and I have my doubts whether all those in this grey area realize what they are doing, on both sides of the debate. A short, but not exhaustive, checklist:

  • if you are blaming [insert country] exclusively, for instance, it is very likely that you are moralizing. An example: the Eurozone brinkmanship consists of more than one player, hot capital inflows are difficult to manage for any country, as Germany may learn in the years to come etc.
  • if you indulge in negative stereotypes, you are obviously doing it: lazy [insert countrymen], imperialistic [insert, well, Germany], … Note to non-Germans: suggestive uses of words like Reich, Anschluss, Grossdeutschmark carry a moralization and sound offensive to most Germans. They are (without exception!) unnecessary to analyse current events.
  • if you criticize the other side of moralizing, you often come close to moralizing yourself, if only by offering a counter-moralization of your own. That is dangerous territory, not every reader may understand that you were just trying to prove a point. Or weren’t you?
  • if you point out moral obligations (on both sides!), if only in suggestive sentences or headlines, you come close to moralizing, and need to be very careful. Example: “[insert core country] gained so much, and therefore…” or “The [insert Southern countrymen] were having a party for years, and have to …”.

I probably need to read my own checklist in the future before I publish a Euro crisis post… All in all, I think it is a good thing that Tyler brought it up.

PS: Tyler has a new reply to some critics. Do read that, too.

Filed Under: Außenpolitik, Gesellschaft, Politische Ökonomie, Presse Tagged With: , , , , , , , , , , ,

Harald Uhlig on debt structure

30. November 2011 Von 6 Kommentare

Harald Uhlig sent me an email in response to my last post on the debt structure of sovereigns, and potential changes to a 4-tier structure. I will comment below, but do read his remarks first:

Creating a seniority structure of sovereign liabilities is a good idea, if alone for pricing the underlying risk.  Private markets do that already, of course (e.g. per CDS etc), some debt covenants perhaps do that already as well, but having country sovereign debt explicitly structured this way would add a lot of transparency: good.  If the stream of payments from the country would not depend on the financial structure, then the Modigliani-Miller theorem tells us, that it does not matter how the liabilities are sliced and diced.

But here now comes the tricky part, and it relates to the “lowest” tranche.  What, really, is country equity?  There is a reason that company equity owners are willing to hold the most junior, residual security: they are the ones with the most say on the company!  The share holders select the CEO and so forth.  For a country, should the “equity” holders now select the government?  Nobody probably wants to go that far.  Then the “country equity” really seems simply a debt security, where the payment stream is rather uncertain.  One could tie the payments to GDP growth etc: but truly, that wouldn’t have helped much in the Greek case.

So, one may need to go all the way and allow countries to simply not pay anything on  these securities.  That may look attractive ex post — but thoroughly unattractive ex ante.  Ex ante, rules and commitment trumps discretion.  In other words, and contrary to Modigliani-Miller, a financial structure in which the country can choose not to pay on certain securities may result in less fund-raising initially than a financial structure in which a country must always repay.  A country that wants to borrow cheaply is best off to promise to self-inflict disaster, if they cannot repay — and then do their utmost so that it never comes to that.  The problem seems to be that the countries cannot achieve this and therefore get themselves into trouble.

So, the truly tricky question appears to be this.  If countries once-in-a-while are simply unwilling or unable to pay on their outstanding securities, and if once-in-a-while they could work extra hard to do so, but it is hard to distinguish these circumstances legally, what is the best way to structure these securities ex ante?  An interesting problem, and debt (with occasional default) or nominal debt with inflation (as in Stokey-Lucas) may be the best way to proceed.  But calling it “equity” suggests a power structure akin to that of shareholders, and that’s not what you’d want.

Let me try to add the following explanation.  Suppose a guy wants to borrow some money today from me and promises to repay 100 Euros tomorrow.  Two scenarios.  First scenario: the guy can just decide tomorrow, that he does not feel like repaying after all, and I cannot do anything about it, and it has no future consequences whatsoever.  Second scenario: the guy has swallowed a pill with a fluid, that will automatically make him very sick for a couple of weeks, but this pill only releases its fluid, in case he does not repay (not sure how one would arrange that, but that’s for engineers to figure out).  And lets say, that I know that he really really does not want to be sick.  How much would I give to him today?  In the first scenario: not much at all, perhaps nothing.  In the second scenario, I would probably give him something near the 100 Euros.  Now, come tomorrow, and in case he really does not have the money, he will be in great misery in the second scenario.  But without that commitment, he could have never obtained the near-100 Euro today in the first place.

In both cases, the default probability is priced: true.  But the harder it is to default, the lower the price for that default.  Ex ante the option to commit is good!  Ex ante, the guy has a choice between scenario one and two,  and will choose what is best.  Ex post, as the example shows, it clearly may not be good, if he had committed ex ante.  That’s the trade-off.

But it is because of this, that I believe that countries by and large will prefer to commit to repaying their debt ex ante, even if so doing may hurt ex post.  At least, they will prefer to have the option to commit. And there will always be that part above the 60% that may give us as much headaches as now.

I am very grateful to Harald for his email and his permission to post it here, as it made some important issues clearer than they were before. First off, “equity” was just the framing to make it easier for the reader to relate to it. But they would just be bonds as the others.

More substantially, the high risks that a default usually entails for the country makes a default a very unattractive option for the sovereign. That is an important aspect: it serves in part as a commitment device. Lenders who know that a default is very unattractive to the sovereign are more willing to lend.

So usually, sovereigns would like to use this commitment device. My proposal basically takes it away: defaulting on the “equity” bonds is a relatively minor disruption compared to a default in the current system. Therefore, countries will have a harder time convincing lenders that they are willing to repay “equity”.

I am not entirely sure, but it could well be a good thing: contrary to “debt brakes” and fiscal supervision, the debt structure would, through market forces and the inability to commit, lead to a lower debt level.

The problem might be to fix this debt structure, but as long as it is written into the debt contracts and formally agreed on, I don’t think that should be the problem: if the “deposit” bond contract says that the sovereign is not allowed to issue more than 40% of this debt and nothing senior to it, otherwise it will be counted as a default, there is not much the sovereign can do but to issue high-yielding “equity” bonds if it needs more loans.

All in all, I think reforming the debt structure could be a useful part of a longer-term solution for the Eurozone.

Filed Under: Finanzmarkt, Makro Tagged With: , , , , , , , , ,

Snow fences for Europe

27. November 2011 Von 20 Kommentare

The debt mountain could use some snow fences, by the_junes

A recent post by Karl Smith  got me thinking about sovereign bonds: is it possible to use the disciplining power of the market in a currency union at all? Or in any country for that matter?

One argument against using the market is that you need to be willing to let countries default — with all that entails. According to a report by the German newspaper Süddeutsche Zeitung, Italy and France are now trying to remove private sector involvement (PSI) from the European Stability Mechanism (ESM) that is bound to replace the EFSF in 2013 because the PSI for Greece allegedly has caused contagion (I doubt that, but that is not the point today).

Another related argument against default (or PSI) is that sovereign borrowing works, until it doesn’t. In other words, the market does not discipline the sovereign through interest rates, but once it does, the self-fulfilling nature of the crisis leads to default. This mechanism, as far as I can see, works for countries with a central bank as lender of last resort as well. It will just hit at a later point in terms of debt load.

Karl proposes “administrative discipline”. Well, good luck with that. Not only is the record of European fiscal oversight dismal, it is also potentially a good way to destroy the friendship between countries in Europe, the original purpose of the European project. It might work, and maybe we need this leap of faith in Europe in the current situation, but without substantial treaty changes (with referenda and all that), it is almost impossible.

But I wonder whether there is, at least in theory, another market-oriented way. For instance, we could structure a country’s liabilities as those of banks, as the IMF suggested in 2004. Let me propose a 4-tier structure: equity, cocos, bonds and deposits.

  • “Deposits” would make up the lower, say, 40% of sovereign debt (relative to GDP). They would be senior to all other claims and the risk-free asset of that country.
  • “Bonds” make up the next, say, 20% of sovereign debt. They are slightly riskier than the deposits, but still a safe investment for pension funds and others given that we are just at the Maastricht criterion of 60% of GDP in debt at this point.
  • “Cocos” are contingent convertible bonds for the next 20% of debt, that convert to “equity” once a certain trigger event happens. Barry Eichengreen suggested cocos, but for slightly different reasons.
  • “Equity” is the most junior claim for debt above 80% of GDP. “Equity” claims are effectively bonds as well. Its coupon payment could be tied to GDP growth of the country to give it a equity-like flavor, but still, there is a principal repayment and other bond-like features.

Regarding the “cocos”, the trigger would be that “equity” needs to take a haircut. Then “cocos” are converted 1:1 into “equity”, after the haircut on the original “equity” is determined. This could be very helpful because it leaves an empty 20% of the seniority structure that can be filled with new coco bonds that arguably will have a lower yield than the marginal equity. Countries in an acute crisis will probably not have a budget surplus and could therefore refinance their deficits through issuing new coco bonds, before having to issue new “equity”.

As far as I can see, there could still be a self-fulfilling “equity” crisis. But it would be limited to the equity part; the more senior claims, when they need to be rolled over, are much less affected and the “deposits” probably not at all (unless markets price in the probability of a Euro exit).

The mental picture I have in my head is that of snow fences against avalanches: yes, there may be an avalanche in one sector of the debt mountain, but it will be blocked by the first array of snow fences, or if it is larger, by the second. You can safely ski under the third.

This setup makes sovereign default a credible threat: it would give regulatory priority to “deposits”, forbids European banks to hold “equity” and thereby isolate the banking sector to a large extent from the sovereign. You also get market signals regarding the sovereign debt, or at least for “equity” and “cocos”.

A few final remarks:

  • Costs: it might not increase the overall costs, as the senior debt would be much cheaper. With the usual debt setup, there is always the danger of dilution such that more debt reduces the value of existing debt. This danger has a strict limit in this model.
  • Incentives: the incentive to borrow short-term is lower, as short-term debt will not be that much cheaper with explicit seniority.
  • Transition: The transition to this new world could be done right away: Spain or Italy would ask the IMF and the Paris Club for help in negotiating the transformation of existing sovereign bonds into these four different categories. Portugal and Greece would do the same. There would be some default on the equity in some countries, but the senior parts are protected, and new cocos could be issued.
    Other countries would make the slow transition, treating all existing bonds as “deposits” and issuing new “bonds”, “cocos” and “equity” over time.
  • Effects: the markets know in this model that some parts of sovereign debt are safe, and others are not. At the moment, the shift from having an ample supply of “safe” assets to a situation where nothing seems safe, is a threat to the financial system, something that would be avoided with the snow fence setup. The forced transition of countries like Italy and Spain also takes away the self-fulfilling nature of the debt, and reduces it to the “equity” part, and possibly the “cocos”.

Please, do poke holes into this proposal, as I am really interested in whether it could work. Also, please post links to related research or proposals that I might not be aware of.

Filed Under: Finanzmarkt, Makro Tagged With: , , , , , , , , ,

Kash Mansori on Italy, Spain and Germany

27. Oktober 2011 Von 12 Kommentare

"The Street Light" responds to my post on Italy and Spain. Street lights in Malta by charakag

Kash Mansori provides his take on competitiveness and the problems of Italy and Spain in a post on his blog “The Street Light”. He raises some valid points, but I still disagree on four aspects: data of the past, Germany’s central bank, Germany’s gain from being in the Euro and German policy during the devaluation.

1. Past data

You shouldn’t reason from past data on something that is almost entirely a forward-looking issue. Past budget deficits or current debt to GDP ratios tell you very little about the sustainability of debt. The future debt burden and the future capacity to pay are what matters.

Italy’s growth prospect is bleak, it hasn’t even started to devalue internally, it is ageing at a tremendous speed and it will have a huge debt burden; Spain has a lower debt burden, but had a construction sector equal to almost 1/6 of the whole economy, a banking problem of unknown size and a mind-boggling unemployment rate of 21%. The internal devaluation that lies ahead of Spain is gigantic.

This is not to say that Italy and Spain are necessarily insolvent, but doubts about their solvency are more reasonable than proponents of illiquid-but-solvent arguments usually admit, and Kash is not exception.

2. Germany’s central bank

Kash argues that Germany is not under bond market pressure because it has its own central bank. What he means is that everyone expects the ECB to backstop a fall in German bond prices and therefore they don’t fall. I am not convinced, at least for the current situation.

A sovereign default by Germany would be against very deeply rooted convictions of the German public. It is no surprise that Gemany introduced a constitutional debt brake based on a party-wide consensus at a time when nobody was talking about sovereign defaults in Europe at all. Germans hate sovereign debt and inflation, and markets know this. Moreover, Germany has already devalued internally and its growth prospect is not bad at all.

Thus, there are plenty of more obvious reasons for Germany’s current position on the sovereign debt market. They, admittedly, don’t fit so well with Kash’s overall position on the Euro crisis.

3. Germany’s gain from being in the Euro

Kash is a prominent voice that suggests that the Euro has benefited Germany before this crisis. For instance, he writes:

The core eurozone countries like France and Germany were in the driver’s seat when it came to setting up this system, and they were happy to take advantage of the common currency when it was to their benefit. They now need to recognize that the responsibility for fixing this mess should really rest largely with them.

And yet he seems to be aware of the fact that Germany had to painfully devalue internally over 8 years. Anyone else noticing the contradiction here? To paraphrase Kash’s statement: Germany benefited from the Euro before this crisis, and the periphery is benefiting now. Doesn’t make sense, does it?

So let us recap a few things here. First, the benefits of facilitated trade were shared by everyone in the Eurozone – not only, in fact not even to a larger extent as is commonly suggested, by an exporting nation like Germany. Second, the other countries consciously traded the ability of adjustment through their exchange rates for lower interest rates, the Euro was not forced on them. The responsibility of fixing this mess should rest with everyone who participated.

4. German policy during the devaluation

As Kash rightly points out, the internal devaluation in Germany happened under pressure. But this supports my argument: as I have said before, pressure is probably needed for a quick adjustment. The 2000 stock boom delayed German adjustment to some extent, and an unconditional liquidity support by the ECB wouldn’t help much either in that respect.

How, then, can we keep up the pressure on Italy and Spain when the ECB is committing itself to buy unlimited amounts of debt? Am I the only one who sees the difficult bargaining game here?

And can Italy and Spain pull it off, once they are forced? I don’t know and it surely is hard. But unless the answer to this question is an unequivocal “yes”, these countries are not solvent. Quite frankly, I am astonished that Kash writes that Italy and Spain are “quite clearly … the victims of a self-fulfilling illiquid-not-insolvent sort of crisis”. Nothing is clear about that.

Let me end with a Dani Rodrik quote from 2010, being asked what Spain needs to do:

First, expenditure cuts are not going to do the job on their own, unless accompanied by policies targeted directly at improving competitiveness.

Second, “structural reforms” (which in the Spanish context means largely labor market reforms that aim to reduce firing costs and decentralize wage bargaining to the firm level) are not a substitute for competitiveness policies.  Insofar as they eat up political capital, they may even backfire in the short-run.

Third, there are no easy solutions to Spain’s competitiveness conundrum.  But the least bad solution is to engineer an economy-wide reduction in nominal wages and the prices of services (utilities, etc.) through some kind of social compact.

Easy?  No.  Any other practical alternative to a prolonged period of recession and high unemployment? Probably not.

That would be the kind of commitment or signal we need. As long as people keep telling Spain (Italy) that they are the victim of a self-fulfilling panic, that it is in fact Germany’s and France’s fault that they are where they are, and that it is Germany’s fault that the Euro crisis is not long solved, it will be harder to convince the people in Spain (Italy) what needs to be done.

Filed Under: Makro, Politische Ökonomie Tagged With: , , , , , , , , , , , , , , ,

You are neither dumb, nor stupid, Paul…

24. Oktober 2011 Von 14 Kommentare

Definitely competitive in 2006, but what about the future? World Cup celebrations in an Italian street, by angelocesare

…, obviously not. But lots of people take an important assumption of your argument for granted.

That, admittedly, was not clear from what I wrote. I was a little sloppy in phrasing my arguments and made it seem like Paul is confusing liquidity with solvency, which of course he is not. So let me try to be clearer this time.

The “illiquid but solvent / self-fulfilling” (SF) argument says that when solvency concerns lead to rising yields, this in turn undermines the sustainability of the debt, leading to yet another increase in yields, etc. Solvency concerns (or speculation in this direction) become self-fulfilling in this case. This argument is intuitive and under certain assumptions correct. Karl Smith actually applied for the title of “most detached econblogger” because he found it to be too obvious to write much about it.

However, the key assumption for multiple equilibria is that the true probability of default is in a certain range in which both equilibria are possible. It doesn’t say that every default is the result of a self-fulfilling dynamic. Contrary to many proponents in the German press, Paul is of course aware of that (emphasis mine):

The point, however, is that Italy and Spain arguably are at risk of suffering from self-fulfilling panics. And you need open-ended credit to avert that fate.

And in an earlier post on the subject, he writes:

In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth. Some people made the SF argument in 2010 for Greece – a politically and institutionally weak country with ridiculous recent inflation dynamics trapped in a currency union with macroeconomically prudish countries like Germany and a stubbornly suicidal ECB. That was obviously wrong, and in my view not only in retrospect. For Portugal, the verdict is not in yet, but as my guest blogger Henry Kaspar pointed out, it doesn’t look good; for Ireland it looks much better now.

For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging. If a country is credibly committed to re-gaining competitiveness, and it has the political institutions to succeed, there is every reason to start unlimited liquidity support to prevent a self-fulfilling panic. If it can’t (like Greece) or is reluctant to (like Italy?!), then what looks at first like a self-fulfilling liquidity-turned-solvency problem is in fact a garden variety solvency problem, and should be treated as such: support, yes, but with heavy conditionality to turn it into a liquidity problem.

As Henry Kaspar writes:

[L]iquidity support should be conditional – conditional on credible assurances, or even better: demonstrated behavior to do what it takes to improve competitiveness and remain solvent. Any liquidity provider – be it the ECB, or the EFSF, or Germany – is perfectly right to insist on this. Unconditional liquidity support provokes unsustainable behavior, and therefore risks undermining the sustainability of the euro area instead of promoting it.

Exactly. So don’t blame Germany alone (unless you are talking about monetary policy) for a political mess that is founded to an underappreciated extent on other countries’ unwillingness to aggressively restore competitiveness.

PS: I should also point out that my presentation of Germany and its internal devaluation between 1998 and 2006 was not meant as a “look how good we are” example, but more as a “damn that was hard” example for why I am sceptical that Italy and Spain are solvent, let alone Portugal or even Greece.

PPS: See also Ryan Avent’s response to Henry’s post.

Filed Under: Makro, Politische Ökonomie Tagged With: , , , , , , , , , , , ,

Solvent? Who said solvent?

19. Oktober 2011 Von 30 Kommentare

Are they also on the same page when it comes to reforms? by Oxfam

The German government remains under attack for not “taking leadership” in the Euro crisis. This rests on the assumption that a known solution is ready to be implemented, but the German government just refuses to accept it. That is wrong.

How many times have you witnessed people changing their opinion about the Euro crisis, while being very confident at the time? This is Joe Stiglitz in February 2010:

If the rest of Europe stands behind Greece, interest rates will come down and then it is easy for it to service the debt. There is a vicious circle here: if people don’t believe it will service it, interest rates go up and then there is a problem.

“A default by Greece is absurd” is what he says later. Sounds familiar? It is the argument that is used for Italy and Spain these days, countries that are “illiquid but solvent” as the popular opinion goes. Isn’t illiquidity always a sign of doubts about solvency? Never mind. Paul Krugman, pointing to Paul de Grauwe, is endorsing this argument as well as The Economist, Willem Buiter, and many others.

I am not saying that Italy and Spain are insolvent (whatever that means for a sovereign country anyway), what I am saying is that their solvency is far from certain. I recommend to take a look at Germany, a country that went through eight years of painful internal devaluation, starting from a much lower debt burden. And it had a functional political and economic governance system (in comparison to Italy) that introduced a so-called debt brake completely without outside force based on a party-wide consensus. Add on top of that the indifference of most European economists and policy makers to the contractionary monetary policy of the ECB plus the fact that Germany was (and is) a big country within Europe and thereby a decisive factor for ECB policy, and the growth prospect for the periphery is bleak.

If Spain and Italy want a backstop – that realistically only the ECB can provide – it is their burden of proof to show that German taxpayer money, that does not grow on trees either, is worth risking in this operation. Because if it turns out that Italy or Spain cannot grow out of their debt because they lack the political will and macroeconomic discipline (as they did a long time ago), this backstop will come into effect, backed by German taxpayer money. And the more it is used, the more the negotiating power shifts towards Italy and Spain, who in this scenario would have shown their lack of political will and macroeconomic discipline… You get the idea.

In fact, Italy proved right away that this scepticism is not a phantasm: after the ECB started buying Italian bonds, the Italian government decided that it was not so serious about reforms after all, forcing the ECB to stop the programme.

How can Italy and Spain show that they mean it? I don’t know. Maybe by transferring government-owned enterprises and property as collateral to the ECB? Maybe through a country-wide consensus (!) on a debt-brake or on pension reforms? Or by giving the ECB the right to approve the budget? By legislation on wage setting that ensures that the economy will be competitive in the near future? To be sure, these are all difficult questions, but this proves my point: blaming Germany or its government is an unsatisfactory explanation for the political problems we face in Europe.

In my view, the problems have to get much worse, Greek-style, so that the peripheral governments can push through the reforms that are needed. Blaming Germany, the ECB, the IMF or whoever will be a common theme during this time of reform and hardship, thereby worsening the relationship between the people of Europe further and showing once more what a tragic, devastating and silly idea the Euro really was. God, this is depressing.

PS: The German influence is really ruinous when it comes to monetary policy, the obsession with an inadequate inflation target and the idea that the ECB’s monetary policy is highly expansionary as it is. It would be great if economists from around the world would point that out!

Filed Under: Makro, Politische Ökonomie, Wachstumspolitik Tagged With: , , , , , , , , , , , ,

Is Germany “abusive”?

21. September 2011 Von 17 Kommentare

I usually enjoy reading David Beckworth’s posts, but I am not sure his latest post is one of them. While I also don’t agree with his conclusion (my guest blogger Henry Kaspar, however, does to some extent), it is mainly the arguments in between that require further discussion.

In short, David claims that the ECB is strongly influenced by the German monetary tradition (true), that the ECB made a monetary policy that was fitting for Germany (wrong), that Germany has a “history of abuse” (?) and that therefore Germany should leave the Euro.

I start with his second claim which I think is wrong. Germany was suffering for almost 10 years after the introduction of the Euro from a lack of competitiveness that was hard to tackle given a much too low inflation. Yes, I know, some backward looking Taylor rule with some output gap assumption (hard to get right in a country with massive unemployment) may say otherwise. But isn’t it striking that David’s charts clearly show how nominal spending in Germany grew at a mere 2% (!) whereas the overall European NGDP growth was around 4%?

Wouldn’t a German central bank have acted differently, given 12% official unemployment in 1998 and 2005 and very low (or in Trichet’s words: impeccable! impeccable!) inflation between 1998 and 2004, not to mention such a miniscule core inflation (see chart). Of course it would have.

(HICP for Germany minus food and energy, annualized % change, source: ECB)

Regarding the “history of abuse”, he is referring to Germany’s behavior in the currency crisis of 1992 where Germany insisted on its monetary policy and drove other countries out. The same seems to be happening now. The German monetary tradition, that still shapes the ECB, is devastating for the Eurozone: A headline-inflation-dominated target of below 2% is bad economics for such a diverse monetary union, but hardly any German economist, let alone politician, realizes this. What is more, the ECB is not even tackling the drop of European inflation expectations to a catastrophic 0.6%. Why they don’t do it is beyond me.

However, as noted above, Germany’s insistence on an inadequate monetary policy did also negatively affect Germany before 2006. Germany was abusing itself as much as it is abusing other countries now. Behind this, I think, is just a deeply rooted misunderstanding of monetary economics in all parts of German society: from politicians to bureaucrats, from economists (!) to journalists. That is, admittedly, bad news for the Eurozone.

Whether a German exit from the Euro is the best idea, I am not so sure. If we cannot manage to let Greece default because of a banking problem, how should core banks manage the exit from the Euro? How do you impose capital controls on such a scale in the single market that is the EU? I think if we work hard and creatively on improving the macroeconomics of the Eurozone, it might work in the future. Given the political resistance to a break-up of the Eurozone, we should focus on that.

Filed Under: Makro Tagged With: , , , , , , , , ,
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