German fiscal simulus

18. Mai 2012 Von 1 Kommentar

The WSJ has an interesting piece about the potential and likely effects of German fiscal stimulus (by Amit Kara, UBS):

The euro-zone economy is stagnating, and many argue that Germany is partly to blame. German households and corporations tend to save, and the country runs a large and persistent current-account surplus. That implies a deficit in other euro-zone countries. …

Germany runs a small and manageable fiscal deficit of just 1%, but the stock of government debt is high at 80% of GDP. And with a potential GDP growth rate of just 1%, any initiative that raises the debt level of Europe’s strongest economy may well bring into question the sustainability of both its own debt and that of the entire euro zone. Put differently, Germany does not boast the fiscal strength that many assume. …

All in all, an expansion in German domestic demand would have, at best, a marginal impact on the economic growth prospects of the periphery.

Do read the entire piece! One aspect that Amit does not tackle, but which I think is important, is the likely ECB reaction to an increase in German demand and its likely inflationary consequences. And I am afraid, we have to take the ECB as given…

HT: Tyler Cowen who has more.

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The Economist on German macroprudential regulation

3. Mai 2012 Von 3 Kommentare

The Economist picks up the same issue as I have in my last two posts: is it possible for individual countries to employ macroprudential regulation to counteract monetary policy nationally? Is it useful if Germany does so? Here are some bits, but do read the whole article:

But if Mr Weidmann is minded to take pre-emptive action, he will soon have the means to do so. … Such powers should be particularly useful in the euro area, providing countries with a national lever to pull if their banks are getting too festive (though Spain’s pre-crisis policy of “dynamic provisioning”, designed to get local banks to set aside more provisions in the good times, cautions against investing too much hope in macroprudential tools).

But in the current climate there is also the danger that such regulations may be used in bigger economies to grab back power from the ECB. By reducing credit availability national central banks can contravene the euro zone’s wider monetary stance. Speaking in New York in late April Mr Weidmann said that if monetary policy becomes too expansionary for his home country, “Germany has to deal with this using other, national instruments.” If Mr Weidmann does use his new powers overzealously that could dash one of the few remaining hopes for the hard-hit peripheral economies: a strong recovery in the euro area, led by Germany.

I disagree, as I discussed before: containing the boom in Germany will give the ECB the needed space to continue to support the periphery.

Whether the Spanish did employ these tools with the necessary force, and whether that is possible in a currency union with free capital movement is of course a difficult question. What do you think?

PS: Also check out this post over at Social Europe Journal by David Lizoain on the problem of measuring inflation and housing correctly. I haven’t thought much about this issue yet, but it is worth delving into.

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How should we divide AD in Europe? Some responses.

2. Mai 2012 Von 15 Kommentare

Tim Duy, one of the best Fed-watchers out there (this was a hint for my German readers, elsewhere everybody knows this anyway), has a very good response to my last post in which I asked Paul Krugman for help, basically on how to divide aggregate demand (AD) among the countries of Europe. But Paul is very busy debating Ron Paul promoting his new book (Hands up, who else did not know about the price policies of Diocletian?), so I am more than glad to have such a substantiated response from someone else. Further below are my responses to email comments from Matt Yglesias and Karl Whelan.

Tim Duy

Tim is critical of my proposal to have the ECB tighten lending standards in Germany, and trying to do the reverse in the periphery:

I think this approach suffers from a number of challenges. First, if capital is relatively mobile, it would be difficult to prevent a loan in Spain from making its way to Germany, so I am not sure the ECB can produce a differential monetary policy. Second, it is not clear that easing lending conditions in the periphery would encourage additional spending. I don’t think it will be all that easy to reverse the process of private sector deleveraging in the periphery simply by easing lending conditions.

These are fair points, and I also think the tools of the ECB are limited. But I do believe that capital markets in Europe are less than perfect. Especially in the real estate sector, the scope for intervention in Germany is large enough to make a difference.

His second point is something I have also wondered about, and it is probably the weakest part of my argument: how do easier lending conditions and lower interest rates in Spain lead to more AD there? My best take on this is: it prevents excessive deleveraging, by lowering refinancing costs. Think LTROs. Moreover, low costs of financing could mitigate the fall in house prices, with all the positive consequences for banks and households. Think: German pensioners buying a house in Spain, and not in Germany where it is made difficult by regulation. This also benefits the Spanish government which can then scale down its austerity measures. Finally, and this is an aspect that has not been covered enough: whoever buys Spanish assets wants to refinance them in Spain, as a hedge against redenomination risk. Low interest rates and a broad range of accepted collateral do help here. Thoughts are welcome on this!

Where I disagree with Tim is here:

Also, I can’t imagine that slowing the German economy, and by extension, the overall Eurozone economy, by enacting tighter credit conditions is in anybodies economic interest. I am skepital that this demand will suddenly appear in Spain. And this, I think, is fundamentally the error in Kantoos’ argument – he seems to see this as a zero sum gain. … [A]cting to slow growth in Germany will only aggravate the drag in the periphery, thus generating more of the hysterisis effects decribed by Kantoos.

There certainly are some frictions as to how demand moves across Europe. However, the ECB will certainly react to inflation in Germany, limiting demand in the Eurozone as a whole.

I think I can even turn Tim’s argument on its head (feet?): at low levels of inflation, we are no longer so sure how inflation reacts to changes in AD. At low levels, inflation might not change that much. If we take the ECB’s inflation focus as given, how can we generate the most AD in Europe? You could make a convincing argument here that zero inflation in the periphery, but high inflation in Germany would force the ECB to lower Eurozone AD, compared to the scenario where stimulus went to the periphery, and we only have modest inflation in Germany, but hardly higher inflation in the periphery, despite the stimulus. My preferred policy might therefore not just shift AD towards Spain, but increase AD in the Eurozone overall.

Tim further refers me to an older post by Paul Krugman and his view on European inflation. But as long-term readers of my blog know, I fully share Paul’s view: we need a higher inflation target in Europe such that countries during adjustment don’t fall into disflationary traps. But this is different from my original point, where I take the ECB and its policy goals as given. That is a fundamental difference: taking the ECB as given means that we have to worry about how we distribute inflation around an average of 2%. Some commentators want to distribute 4% to Germany, and -2% to the rest. I want to distribute the inflation more evenly: 3% in Germany, and 1% elsewhere.

Matt Yglesias

This all leads nicely to a comment I received from Matt (via email). His idea is that Germany could lower its VAT as a stimulus. It has the advantage of tricking the ECB into allowing more AD in Europe as a VAT cut will lower (headline) inflation in Germany. This could be a good idea, but such a stimulus will lead to wage increases down the line as well, and then lead to a ECB response eventually. Which is why he contemplates to convince German unions in return to lower their wage demands. This is the moment, where the last person should realize that “rebalancing” is not the goal, but a means to an end. The real question is: given the constraint that the ECB will react ot inflation, what is the best thing to do for the periphery? The answer to that question is more difficult than it might seem.

Karl Whelan

All of this is an academic debate, of course, as there is no European government to decide about this, but national governments and Germany is reluctant to apply stimulus. Karl’s critique (via email) therefore mainly focused on feasibility. And he may be right: setting up a fiscal policy fund like I proposed might be way out of reach at the moment, so the second best is stimulus in Germany.

But is stimulus in Germany really more feasible? Let’s not forget that the German parties, under pressure by the public!, introduced a debt-brake based on a party-wide consensus way before this crisis. Now that unemployment keeps falling, and budgets look better than ever, this debt brake will prescribe truly Keynesian policy: run surpluses during good times. Violating this debt brake, given the current situation in other parts of Europe, is political suicide in Germany and not as feasible as it may look from the outside.

I am going to make an optimistic claim here: Hollande’s win in France will make Merkel re-evaluate her policy options. Merkel in general does come around to what is the right thing to do if the pressure is high enough – especially if she can thereby steal the left parties’ thunder. And she does have the ability to explain her turns to the people in Germany, without losing too much credibility. It happened before: a move towards more modern family support in Germany, the phase-out of nuclear energy, a minimum wage…

But since Merkel does not read Kantoos Economics, it might be a while until she realizes what’s right. :)

PS: One remark for my German readers. Hans-Werner Sinn beklagt sich in einem Brief an den Handelsblog darüber, dass die stützende EZB Politik im Süden Europa (Stichwort: LTROs) ja die Zinsen in Deutschland ceteris paribus erhöhen würden. Genau das ist mein Argument, nur finde ich es gut und richtig – im Interesse Deutschlands! – dass dies geschieht. Denn niedrige Zinsen sind nicht per se gut, sondern im Verhältnis zur natural rate of interest zu bewerten, aus makroökonomischer Sicht. Langfristig ist die Fragestellung etwas anders, denn die Zinsen in Deutschland werden vielleicht dauerhaft niedriger bleiben.

PS: Und noch eine Leseempfehlung, das Interview mit Rüdiger Bachmann im Fazit. Pflichtlektüre!

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A European macro-question for Paul Krugman

30. April 2012 Von 43 Kommentare

Rebalancing Europe is hard, the tower of Pisa by r12a

What do you do, when a (macroeconomic) debate is hard to settle? Well, you can either leave it at that, and agree to disagree. Or you can try to find a referee to settle it for you. I will try the second route today, and I hope that Paul is willing to help me out.

The problem is this:

We know what the basic macroeconomic problem of the European periphery is. They have run up high debt levels, either privately or publicly or both, which were in part financed by the excess saving in other countries. Now, debt levels are high and prices and wages are at an uncompetitive level.

What we need to do in Europe is to “rebalance”. It means different things to different people, but essentially, we want Germany to have higher inflation, to reduce its current account surplus, and the periphery to do the reverse.

One proposed solution is for Germany to employ fiscal stimulus at home, to increase domestic inflation and increase investment and spending. Simon Wren-Lewis goes as far as to argue that this is what a truly but hypothetical European government would do. I disagree: a European government would employ stimulus in the periphery, not Germany.

So here we are. I know that this is a somewhat academic debate, as there is no European government. But knowing what the social planner would do is always a good benchmark. I would like to make my case once more, but in slightly more detail.

We live in a Keynesian world here in Europe, where downward wage adjustments are very hard. Add to this high debt levels, and it is clear that the internal devaluation process, in the midst of a deleveraging process by households, banks and firms, together with austerity will doom these countries to deflationary recessions. In order to find the optimal way to proceed, we can look at this in two related ways: interest rates, and aggregate demand (AD).

Let’s look at this through the real interest rates window first. The natural rate of interest is currently very low in, say, Spain, and relatively high in Germany. Since ECB policy is made for the average, and inflation in Spain will be low in the foreseeable future, their actual real interest rate will be very high. In Germany on the other hand, where inflation will even be high absent any further stimulus, the real interest rate will be low – the exact opposite of what is needed. Welcome to the weird economics of a suboptimal currency union.

What the ECB should do is to toughen lending standards in Germany, raise collateral requirements, down payments etc., and do the reverse in Spain. This should limit investment and consumption in Germany, and encourage it in Spain. It should mimic a differentiated monetary policy, and try to come as close as possible to the respective natural interest rates.

Looking through the AD window, the issue looks the same: AD in Spain is much too low to support the economy. The optimal level of AD in the Spanish economy, given the uncompetitive wage and price level, is the one that results in 0 + ε % inflation (in theory, in practice the number would be higher, but you get the idea). This way, the necessary adjustment produces the minimum level of economic pain. Arguably, Spanish AD is well below that level.

German AD is sufficient, and extending it further – given the ECB’s 2% inflation target – takes away AD from the periphery. This is easiest to see through the eyes of a Market Monetarist: overall AD in Europe needs to be kept constant by the ECB. If Germany allows more AD at home, AD needs to be taken away elsewhere. And the ECB’s reaction to inflation pressures in Germany is not something I am making up here, at least according to the FT.

In my view, the optimal policy – taking ECB policy as given – is to add monetary and fiscal stimulus to the periphery (only), as far as that’s possible, such that the period of adjustment is less painful, and limit the overheating of the German economy. I want the stimulus necessary to produce 0 + ε % inflation in Spain, and whatever inflation is necessary in Germany to result in 2% overall, for example 3% (Germany is a big country).

Simon’s preferred policies would result, as far as I can see, in overheating Germany, and letting Spain fall into depression. The quick but painful route to rebalancing, if you want: Spain suffers through a depression, and German enjoys a boom with inflation of 4% or more.

There are several reasons why I think my policy suggestion is better. First, a depression in the periphery can become self-enforcing and long-lasting, leading to bank failures, hysteresis, the whole menu of economic nightmares. Second, Germany’s overheating would have costs as well, and we shouldn’t repeat the same mistakes that led us into this mess in the first place: uneven macroeconomic developments. Finally, rebalancing is not a goal in and of itself. It is a means to an end. This end is economic well-being, and in a currency union with a 2% headline inflation target, the best way to foster economic health is to limit the hardship during adjustments.

Hopefully, Paul can help me out: what am I missing here? In terms of actual policy, of course, Germany won’t do any stimulus at home anyway, as it is not in the German interest to do so. But I think the interests of Germany and the rest of Europe are well-aligned here for the above reasons.

Stimulus in the periphery is hard to accomplish, but the ECB could loosen policy (LTROs is a case in point) at the same time that Germany tightens lending standards, imposes higher transaction taxes on property, unilaterally increases capital requirements in banking etc. Regarding fiscal policy, my hope is an independent European fiscal policy fund, where each country has an account of, say, 20% of GDP that needs to be repaid in (AD-wise) good years, which are defined by above-target core inflation rates. This (jointly guaranteed) fund can be drawn on, much like the IMF, in return for some jointly agreed reform packages and ways to spend the stimulus. Any thoughts on this?

Two further remarks:

  • Simon argues that a higher inflation target for the ECB would have the same result as fiscal stimulus in Germany only. I strongly disagree. If a central bank increases the inflation target, and wages and prices subsequently rise with a higher rate, we are still in a macro equilibrium. If a government, despite a constant inflation target, overheats the economy, we are outside the equilibrium and wages and prices will be too high in the end, and will have to come down again. That is a major difference.
  • We all agree that ECB policy should be more accommodative overall, but Simon argues that the ECB is stuck at the zero lower bound (ZLB) as well, which I am not sure I agree with. There is plenty of room for QEs. What is more, ECB rates are currently at 1%, not zero. Finally, the LTROs amply prove that the ECB has other tools available, not to mention level targets.

PS: Do check out the Bruegel blog review on austerity. And while you are at it, Brad DeLong recently tweeted a link to a very interesting 2009 post on fiscal policy on his blog, where he spells out the four ways in which fiscal policy matters. And if you still can’t get enough of fiscal policy and imbalances, check out the papers that were presented at the Economic and Monetary Affairs committee of the European Parliament (HT Shahin Vallée at Bruegel).

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Rebalancing, monetary policy and ESBies

6. April 2012 Von 6 Kommentare

Part 1

Guntram Wolff has a short post over at Bruegel on European rebalancing, which fits well with my recent posts (one, two, three) on Germany’s current account surplus. He writes:

If we assume that productivity in this period will grow by around 1.3% and euro area inflation is at 2%, the adjustment in terms of competitiveness is really very marginal. In fact, it would be around 1% relative to the euro average over two years. So even if all wage agreements in Germany were to follow the public sector agreement – which many Germans consider as a very strong agreement – one can hardly say that an adjustment from above has picked up strongly. To close a gap of 20-30%, it would take some 20-30 years. Having annual inflation rates of 2.5% in Germany and 1.5% in the South is much too little an inflation differential to close the competitiveness gaps anytime soon.

I disagree a little here. The public sector is not the main driver of adjustment. The main industrial union (IG Metall) has entered the negotiations with 6.5% increase for one year. Second, he assumes inflation of 1.5% in the periphery. Is that realistic? For headline inflation, it may well be but for the more important core inflation, we should not see more than 1%, if at all.

PS: While you are over at Bruegel, also check out this summary post on the gold standard vs. the euro.

Part 2

David Beckworth is critical of the latest move of the Bundesbank to unilaterally tighten monetary policy, as is Ambrose Evans-Pritchard. But if you think about it, Germany is trying exactly what we should learn from this eurocrisis: to use macro-prudential tools to counter an unsustainable boom based on credit, banking and real estate. This will effectively differentiate monetary policy across European countries, but this is exactly what we need! I have no idea why David thinks that this is the beginning of the end of the eurozone.

Will this differentiation prevent rebalancing? I am not sure. On the one hand, it would help the south if the German economy overheats. This will drive up demand, increase wages and prices and lower the need for wage declines in the south. On the other hand, if Germany restricts the boom, but the ECB needs to achieve an inflation average of 2%, it needs to loosen policy further. This benefits the south in other, and arguably more important ways.

Or stated differently (for Market Monetarists), overall AD needs to be kept constant by the ECB. If Germany does not allow more AD at home, the AD needs to be created elsewhere. As I said before, in response to Simon Wren-Lewis, it is best to create some extra demand in the south, rather than overheating the German economy.

PS: Could British commentators please stop using World War metaphors like “blitz” when discussing the eurozone troubles!? We have enough moralizing in Europe as it is…

Part 3

Over at Wirtschaftswunder, Andre Kühlenz discusses (in German) a type of synthetic Eurobond: banks should leave a weighted portfolio of all eurozone government bonds at the ECB, instead of individual bonds. Interestingly, he writes about this idea without referring to the most famous proposal in that direction. One aspect, that caught my eye, was this:

Es wäre jedenfalls in meinen Augen ein effektiver Backstopp gegen die Kapitalflucht im Euro-Raum, denn die Banken müssten immer wieder Papiere der Länder nachkaufen, wenn sie sich Geld von der EZB leihen wollen.

In effect, he is saying that such a proposal would limit capital flight: banks would have to buy the bonds of all countries when they want to get money from the ECB. This is exactly one strong aspect of such a synthetic eurobond idea: it mitigates the flight to safety.

PS: For interested readers, I recommend having a look at the website of the proposers.

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What would a European government do?

2. April 2012 Von 23 Kommentare

A European government in Brussels? A view on Brussels, by MPBecker

Simon Wren-Lewis has an excellent post over at Mainly Macro, in part a reaction to my two recent posts. He discusses three aspects of the Eurocrisis: 1. austerity (based on the DeLong/Summers paper) in general, 2. its implications for Europe, and 3. Germany’s role in rebalancing Europe. Do follow the link and read the post, it is too good to be summarized here. Especially the neat graphical representation and short explanation of the DeLong/Summers argument is a great example of economics blogging. I also like the way he phrased the argument for austerity in Europe:

In the case of Ireland and other Eurozone countries the immediate motivation for austerity is a high risk premium on government debt. What potential investors in Irish government debt are worried about is not where debt is likely to end up, but the likelihood of default before we get there. Here the credibility argument does apply.
                … Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Promises to cut it in the future carry much less weight, and so as a result have less impact on the chance of default.
               [D]efault is less likely if debt follows the black line (austerity) rather than the red line (stimulus). The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared. So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense.

On Germany’s role, Simon has this to say:

Kantoos’s final question in his post is: ‘So what else should Germany do?’ Germany should be reasonably relaxed about getting its own debt to GDP ratio down. What I have called ‘competitive austerity’ in Europe is not helpful. But being more relaxed on debt is not going to make a big difference to the rest of the Eurozone. So the realistic answer to that question is probably ‘not much’.

I disagree, however, on Simon’s hypothetical prescription:

If there was a Eurozone government, it should be undertaking a substantial fiscal stimulus in Germany right now.

Two things are wrong with this. First, fiscal stimulus should be applied where aggregate demand is too low to support the economy, that is, in the contracting regions. The reason is simple: we know that nominal wage declines are nigh impossible for various reasons, and may in fact not even be helpful. If aggregate demand contracts such that wages and prices are too high, but declines are impossible or counter-productive or both, we will witness a recession, unemployment and potentially a self-reinforcing downward spiral. Counter-acting such an economic decline is the main task of any macro stabilization policy. The stimulus in the periphery should not be too much, though, in order not to prevent the necessary adjustments of wages and prices, and probably also a few institutional reforms.

The reason I discussed German fiscal stimulus was that the German taxpayer is highly unlikely to fund fiscal stimulus in, say, Portgual. The German public may, on the other hand, be willing to fund German stimulus, which (via overheating the German economy) will make the amount of adjustment in the periphery slightly smaller. But there cannot be much discussion that a fiscal stimulus in the periphery would help ease the transition much more, can there?

Second, the main stabilization policy is monetary policy, and I am very glad to read that it is Simon’s main hope. DeLong and Summers argue as well that unless monetary policy is constrained, it should be the main stabilization policy. And the ECB is currently unconstrained and still has failed to maintain macroeconomic stability – in fact, a temporary commodity boomed led to two interest rate increases, just before the the Eurocrisis got out of hand. Coincidence? Hardly. A more accomodating monetary policy would increase AD everywhere in the Eurozone, allow German wages to increase faster without having to go down again after fiscal stimulus runs out, and speed up the competitive adjustment in the periphery. May his hope (and mine) come true.

An ideal European government would therefore do three thing: First, it would institute a monetary policy regime that does not narrow-mindedly focus on headline inflation but that does stabilize the nominal economy in Europe, ideally with a nominal GDP level target, targeting the forecast of course. Second, it would use all available tools (from macro-prudential regulation to monetary policy to fiscal rules) to manage the macroeconomy better and prevent regional booms and unsustainable sovereign debt. Third, it would conduct regional fiscal stabilization policy to support those regions that are in contraction despite the tools mentioned before, while at the same time forcing the countries to conduct the necessary reforms.

Fiscal stimulus in Germany, however, would not be on such a government’s agenda right now.

PS: In case you don’t know Simon’s blog (silly you…), start with this post, and then go on to this one.

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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.

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