The Holy Roman Eurozone

I started writing this post yesterday. It's already out of date. This is what I wrote yesterday; I will continue the post below.

Greece has now gone, at least in expected value terms. With bond yields increased to over 13% today, there is no way I can see Greece running a primary surplus big enough to pay those interest rates on its outstanding debt. When you have a debt/GDP ratio of 100%, every one percentage point permanent increase in interest rates increases the deficit/GDP ratio by the same one percentage point. Yields increased three percentage points just today. Yields in Portugal, Ireland, and Spain also rose, though by smaller amounts. Bond markets do not expect the cavalry to arrive on time, if at all.

Felix Salmon's depressing post explains why the German cavalry won't come. He talks about the consequences for European commercial banks, and their need for a rescue.

I'm more interested in how the European Central Bank will respond. I am certainly not an expert on the ECB, but when you can't find anyone who is an expert tackling this question, you have to make your own stab at it; even if you get things wrong.

Normal central banks buy things; that's how they create money. They print money, buy something with it, and that money then goes out into circulation. Mostly what they buy is bonds, the bonds issued by the government that owns the central bank. They do a little bit of colateralised lending to commercial banks on the side, just to fine-tune monetary policy, but it's usually small beer. And if they want to, and get the nod from the government that owns them, they can and will buy almost anything in an emergency, and lend to almost anyone against almost any colateral they feel like.

The ECB is not a normal central bank. It doesn't buy things. It lends to commercial banks against colateral of bonds issued by the Eurozone governments. It's a pawnbroker.

That's what I wrote yesterday. Now back to today. Yields on Greek bonds were at 18%, last time I checked.

It's not just Greece; I now think the Eurozone has gone. Not gone completely; it will live on in some form, just like the Holy Roman Empire, a shadow of the original, comprising maybe Germany, France, and Benelux.

Normal countries have their own central bank. In an emergency, if there's a run on the country's government bonds, the central bank can and will print money to buy unlimited quantities of those bonds. Provided those bonds are promises to pay the domestic currency, which the domestic central bank can print, the debt can always be paid. Just print whatever you have promised to pay. Another way of saying this is that a normal government, with its own central bank, does not have a binding nominal budget constraint. It can spend as much as it wants, if we measure spending in units of the domestic currency. It has a real budget constraint, measured in real goods and services, but only because the Long Run Phillips Curve tells you that printing too much money will only cause inflation, and the demand for money curve tells you there's a limit to how much money, in real terms, people are prepared to hold.

Of course, the consequences of printing a lot of money can be unpleasant. Inflation, depreciation of the exchange rate, and higher interest rates if you ever wanted to borrow again in future. But, if part of what caused your fiscal problems was recession, deflation, an overvalued real exchange rate, all caused by an excess demand for money, then a little bit of those side effects of the medicine is just what the country needs.

The Eurozone countries are not normal countries. They do not have their own, tame, central bank. They face both a real and a nominal budget constraint. They are vulnerable to "runs" on their government bonds -- an ugly feedback loop where solvency and liquidity crises reinforce one another through rising bond yields and increasing uncertainty about the true value of the bonds.

It's a mug's game trying to predict where contagion will spread. But I'm a mug.

The UK is part of the European Community, and has fiscal problems of its own. But it also has a central bank of its own. If my theoretical perspective is right, the UK will escape. So will other countries with their own central banks. Let's see.

And eventually what's left of the Eurozone will order the ECB to buy their government bonds, if ever they need it to.

Comments

[Jim Rootham]

Jane Jacobs predicted this a long time ago. "The Economy of Cities" I think.

Her point was that over time there gets to be 1 rich city per currency, since the value of the exchange rate is most appropriate for 1 city in the currency. That city prospers and increases its influence on the exchange rate. Unless something else happens that pushes the exchange rate off what that city wants the central city will eventually dominate.

It can take a long time, so large wealthy regions (like the US) will appear immune.

[Nick Rowe]

I really like Jane Jacobs. But her reasoning was wrong on this one. She had a very good intuitive understanding of how flexible exchange rates work. But she had no understanding of fixed exchange rates. She didn't get the distinction between nominal and real (adjusted for relative price level) exchange rates. David Hume had a much better understanding of fixed exchange rates, in his "price-specie flow mechanism". In the long run, the price level in Greece can fall, and the price level in Germany can rise, depreciating the real exchange rate of Greece against Germany.

It's fine for long-run analysis. But Greece can't wait that long. Its (inflation unadjusted) debt is due next month.

[Jim Rootham]

I think Jane's point was that price level adjustments were painful and damaged the economies that needed their prices to fall.

[Patrick]

Krugmam: The Cohesion Crisis

"Greece seems to be spiraling over the edge into default; I just don’t know how it steps back from that edge now."

Maybe I'm being melodramatic, but it seems to me that the Europeans are really playing with fire on this one.

[westslope]

Maybe the Europeans are punishing the Greeks? I know I would.

[westslope]

And punishing bond holders would be a good thing too.

[JP Koning]

Hi Nick,

"The ECB is not a normal central bank. It doesn't buy things."

My understanding is that the ECB can buy and sell through open market operations, just like the Fed. The operations may include the debt of member governments.

See http://www.ecb.int/mopo/implement/omo/html/index.en.html

The rub is that the ECB cannot buy directly from national governments. It can only buy in the open market. In this respect it is entirely like the Fed. The Fed can neither buy from nor lend directly to the Federal government nor state governments. The Bank of Canada is a bit different in that it can lend directly to the federal government and provincial governments (for limited durations and amounts).

So far there is no difference between the Fed and the ECB.

The one major difference though is Article 103 of the treaty governing the EU, the "no bailout clause". It prevents the European Community and its member states from assuming the debts of any other member.

"A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State..."

If the U.S. were to have this sort of arrangement, which it doesn't, all the states and the federal government itself would be prevented from lending to one another. So if California went bankrupt, neither Washington D.C. nor Washington could support it.

Anyways, it seems to me that what makes the European situation abnormal is not the ECB, but Article 103. Greek officials knew about this rule going in, and unfortunately normal Greek citizens are now being made to suffer for the financial ineptitude of their government.

[JP Koning]

Hmmm. Under the Treaty of Lisbon, which amended the Maastricht traty, Article 103 was renumbered as Article 125. Cheers.

[Too Much Fed]

"Normal central banks buy things; that's how they create money."

Care to break that down into currency and currency denominated debt?

[Too Much Fed]

"They print money, buy something with it, and that money then goes out into circulation."

Exactly how do central bank reserves get into circulation?

[Too Much Fed]

"And if they want to, and get the nod from the government that owns them, they can and will buy almost anything in an emergency, and lend to almost anyone against almost any colateral they feel like."

Nothing like bankers bailing out other bankers to keep themselves rich and powerful?

[Too Much Fed]

"Provided those bonds are promises to pay the domestic currency, which the domestic central bank can print, the debt can always be paid."

Assuming the debtors are experiencing negative real earnings growth, why should the creditors be bailed out to maintain their excess positive real earnings?

[Too Much Fed]

"Of course, the consequences of printing a lot of money can be unpleasant. Inflation, depreciation of the exchange rate, and higher interest rates if you ever wanted to borrow again in future."

But if "someone" is trying to "pull an IMF", isn't that what some people say is required to force an economy to become a net exporter to pay off the spoiled, rich foreigners?

[Too Much Fed]

"The UK is part of the European Community, and has fiscal problems of its own. But it also has a central bank of its own. If my theoretical perspective is right, the UK will escape. So will other countries with their own central banks. Let's see."

But what happens when "everyone" tries to become a net exporter at once (especially by currency depreciation)?

[Paul]

"But what happens when "everyone" tries to become a net exporter at once (especially by currency depreciation)?"

Is this likely to happen? Since Greece cannot become a net exporter by depreciating the Euro, they would have to invest in manufacturing improvements to lower variable costs below their competitors. Is there any money left in their system for capital improvements? What about Portugal/Spain/Italy/Ireland? Do these places look safe for foreign investment? I'm leaning to "No" for now.

The point here is that UK and other countries with their own central banks have way more flexibility and options in times of crisis.

Does anyone remember the debates in Canada on should we assume the USD as our currency? Not such a good idea anymore is it?

[Nick Rowe]

Thanks JP. You are a great source of information on this sort of stuff, as before.

But I don't understand the economic importance of the distinction between the central bank lending directly to a government, and buying the bonds in the open market. It seems to be a distinction that is so easy to circumvent. If it is known that the CB will buy govt bonds in the open market at a price P, then private traders will buy the newly-issued bonds directly from the govt, at a price P minus epsilon, then re-sell them to the CB at P.

I also wonder how much formal rules matter in times of crisis. The EU's stability and growth pact turned out to be just a bit of paper. In normal countries the minister of finance and governor of the bank get together and decide what to do. There is no Eurozone minister of finance. Just a load of silly bureaucratic consultations, which won't do anything.

Too much Fed:"

"Normal central banks buy things; that's how they create money."

Care to break that down into currency and currency denominated debt?"

I already did. The Bank prints money (e.g. currency) and buys bonds (i.e. "currency denominated debt"). That's what I already said.

[Patrick]

"what happens when "everyone" tries to become a net exporter at once"

Pretty obviously that can't happen.

If the worst happens and a Greek default results in contagion that takes out a European mega bank or two, and we get Great Recession, Part Deux than we're really going to need the worlds poor to bail out their former colonial overlords. Maybe GS can get into the micro credit business.

(sorry, I'm not very feeling very optimistic this AM)

[Patrick]

The Peterson Institute for International Economics: The Biggest Losers: Who Gets Hurt from a Greek Default or Restructuring

[Patrick]

Grrr! Must've goofed the link. I'll try again...

The Biggest Losers: Who Gets Hurt from a Greek Default or Restructuring

And in case it doesn't work:

http://iie.com/realtime/?p=1521

[Nick Rowe]

Patrick: very good link. Confirms my fears about the pawnbroker problem.

[JP Koning]

It seems to me that it's a lot easier for the government to sell debt directly to the central bank than indirectly to the central bank through the intermediation of the market. Inconveniently for the government, the market is fickle and will weigh and evaluate the government's new debt issue before purchasing it, comparing it to other forms of debt, both public and private.

But if the relationship between government and central bank is a direct one, a pliant central banker can be induced to directly buy whatever new government issue he is told and at whatever rates.

Given an indirect relationship, the central bank can set some price to buy from the public that encourages an arbitrage trade, as you pointed out. But even then that trade is compared with other trades on the market. Private debt issuers coming to market, anxious to compete with the government for the public's savings, may raise their rates in such a way as to compensate investors for foregoing the government-central bank arb trade. This vying in the market for savings inhibits the government's ability to use the central bank indirectly as a financing tool.

When the government doesn't have to deal directly with the market but directly with a central banker, these competitive forces inhibiting it no longer exist, and it can pretty much do whatever it wants.

[Brandon]

I'm too young to remember, but does anyone know whether pre-Euro Greek debt was denominated in drachma or German marks?

[Panayotis]

In the EMU inefficient arrangements with no fiscal authority, national debt is like private debt subject to expected loss given default, uncertainty, "animal spirits" considerations and speculation. Restructuring becomes a valid pre-default arrangement imposing less pain and economic suffering upon the member economy and less damage upon the system as with messy bail outs that can generate member conflicts. Especially, when mark to market requirements of financial portfolios have validated most value discounts neccessary for the restructuring. Austerity measures will only raise the deficit from fiscal stabilizers, debt will rise further and a debt deflation feedback loop will result that will cause further problems to the rest of the eurozone. Notice that in the case of Greece, the private sector has a low debt burden(less than 100% of GDP!) with nearly 40% of GDP unreported, partly saved in bank accounts, real estate or investments abroad(estimated between 200-300 billion euros abroad!). Austerity measures will cause private debt to rise and eventually the private sector will have a sustainability problem as well. Apart from restructuring what is needed is public spending waste control and tax collection efficiency to fight tax evasion.

[Too Much Fed]

Nick's post said:

"Too much Fed:"

"Normal central banks buy things; that's how they create money."

Care to break that down into currency and currency denominated debt?"

I already did. The Bank prints money (e.g. currency) and buys bonds (i.e. "currency denominated debt"). That's what I already said.

From what I can tell the fed did NOT print currency.

I believe it comes down to what are the differences between currency and central bank reserves.

One other way to look at it is my question from earlier, exactly how do central bank reserves get into circulation.

[Too Much Fed]

Paul said: "Is this likely to happen? Since Greece cannot become a net exporter by depreciating the Euro, they would have to invest in manufacturing improvements to lower variable costs below their competitors."

How about the rich person's solution, cut the wages of the workers?

[Too Much Fed]

"But what happens when "everyone" tries to become a net exporter at once (especially by currency depreciation)?"

http://economistsview.typepad.com/timduy/2010/04/we-cant-all-be-net-exporters.html