Why it's a really good thing that the ECB has overpaid for Greek junk bonds

Those of us who argue for monetary policy as a way for countries (and fake countries like the Eurozone) to escape a recession, even in an alleged "liquidity trap", recognise that any increase in the money supply should be permanent, and perceived as permanent, to do much good. Even some Keynesians, like Paul Krugman, recognise that monetary policy could do a lot of good if only it could be made permanent. He just doubts that any central bank could credibly commit to making it permanent.

One way for a central bank to credibly commit to increasing the money supply permanently is to increase the money supply by buying bonds, then publicly burn the bonds. Publicly trash the asset side of its own balance sheet. That means the central bank won't be able to buy back the money in future. So it's a permanent increase in the money supply, and seen as such. Helicopter money is a permanent un-backed increase in the monetary base. Burning the bonds burns the backing, and so burns the vacuum cleaner that might suck the money back up in future. It's like an invading army burning its boats.

A second way is to overpay for junk bonds. That's what the European Central Bank has just done. This second way is better than the first, because it creates a negative feedback loop between the amount of money created permanently and the amount of money that needs to be created permanently. As I shall explain. And for once, just once, it's actually an advantage that the Eurozone lacks a central fiscal authority. Because that means it's much harder for a fiscal authority to bail out the ECB if it gets into trouble, as I strongly hope it will, or be expected to. A bit of trouble, or the perceived likelihood of a bit of trouble, is just what the doctor ordered.

I had totally forgotten I had already written a post on a very similar topic over a year ago, until a comment by PierGiorgio Gawronski reminded me, by suggesting Mr Trichet publicly burn some of the ECB's assets. (My brain is failing.)

In my old post, I said that Ben Bernanke was betting on the economic recovery, using the Fed's own assets, by buying toxic waste. If there is no recovery, he loses the bet, the toxic assets become worthless, and the increase in the monetary base becomes permanent, because the Fed can't afford to retire the extra money. If there is a recovery, he wins the bet, the toxic assets are worth at least what he paid for them, and the increase in the monetary base can be temporary, because the Fed can afford to retire the extra money. That's the demand curve of recovery.

At the same time, the greater the extent to which the increase in the money supply is expected to be permanent, the greater the extent to which the economy recovers. That's the supply curve of recovery.

There's a negative feedback loop between the expected value of the assets and the expected degree of recovery. A demand curve for recovery, and a supply curve of recovery. Somewhere in the middle the two curves cross, and determine the equilibrium level of recovery, and the equilibrium degree of default on Greek bonds.

This negative feedback loop is a way around the "ketchup problem" (the central bank keeps banging the bottle trying to get some inflationary ketchup to come out, and then it all spurts out in a rush).

There was one thing wrong with my previous post. The Fed has a fiscal authority behind it, the US Federal government, that is (so far) solvent, and that might be expected to bail out the Fed if it lost the bet. Which would mean the Fed would be unable to credibly commit to increasing the money supply permanently.

Nobody understands how the ECB operates; and I think that includes the ECB itself. It's pointless looking at the rules, because the ECB, and Eurozone generally, just breaks them. It's some sort of economic/political judgment call. But there is no central fiscal authority for the Eurozone. And it's hard to get 16 governments to agree on anything, let alone stick with it. Especially if they have to come up with cold, hard, tax increases to bail out the ECB and buy back the cash. Especially given the amount of national animosity (already bad enough, from what I read and hear) that bailing out the ECB to cover a Greek default would bring.

So, it might just work for the ECB.

Comments

[The Money Demand Blog]

No:
1. Trichet is careful in not overpaying for Greek bonds. He is not making Greek-Bund spread disappear, he is just returning it to already quite high levels that were prevalent one month ago.
2. Fiscal bailout of ECB doesn't have to be explicit. If EU member states prevent the run on ECB, even insolvent ECB will be able to use IOR to prevent inflation.

[Nick Rowe]

TMDB: The conservative finance guys are complaining that Trichet is overpaying for Greek bonds, and that he's underestimating the risk of default, and all the commercial banks are unloading their Greek bonds onto the ECB. (Where did I read that, just this morning?). And the rates have come down a lot since the ECB started buying, and the rates before the ECB started buying probably reflected some non-zero probability that the ECB would start buying.

(What the finance guys forget, of course, is macro/money: the chances of Greek default, and so the fundamental value of the bonds, depends on how many the ECB buys, because that influences monetary policy. It's like under the gold standard, where the fundamental value of gold is determined by the price fixed by central banks.)

Paying interest on reserves is equivalent to the ECB issuing bonds. Issuing bonds doesn't change the net worth of the ECB. But nevertheless, you have a good criticism here. The NPV of a central bank is much greater than the assets on its balance sheet. It's the NPV of all future seigniorage. In other words, it might have to buy an awful lot of really junk bonds in order to trash its balance sheet sufficiently. Hmmm.

[Luis H Arroyo]

Sorry to contradict you, Nick, but the ECB is not working well. Today, the Eurolibor has risen to 0.70%, the highest since December 2009. You can read in WSJ:
"Euro-zone banks placed to record € 316.4 billion ($ 387.1 billion) in the ultra-safe ECB's overnight deposit facility, ECB data show Wednesday, Bringing back memories of the days Following the collapse of U.S. investment bank Lehman Brothers in 2008. There is a liquidity crisis: the banks would rather lose 0.75% (0.25% -1% official rate)."
This proves that the ECB is sterilizing their bond purchases. We are facing a double dip.

[Nick Rowe]

Luis: Oh dear. Back to my previous Euro-pessimism? The ECB really needs to do unsterilised bond purchases.

[Luis H Arroyo]

OK, Nick, I had not understand truly the idea. After re reading, I agree. By the way, I recomend you the article of Valclav Klause, in WSJ:
http://online.wsj.com/article/SB10001424052748704875604575280452365548866.html?mod=WSJ_hp_us_mostpop_read. a common sense tahat I have not see in Spain.

[Luis H Arroyo]

Sorry again, I'm afraid my English is playing me tricks. But, in any case, the ECB is doing catastrophically

[Andrew F]

If we're seeing another liquidity crisis, this time in European sovereign debt/banks, will we see it spread throughout the whole global financial system? Surely the ECB can't bail out Ireland, Spain, Portugal, etc. And if they don't, many European banks will become insolvent.

I'm having a hard time grasping the scale of this. People seem less concerned than perhaps they ought to be.

[RSJ]

"One way for a central bank to credibly commit to increasing the money supply permanently is to increase the money supply by buying bonds, then publicly burn the bonds. "

That is called fiscal policy. Helicopter drops are fiscal policy. When you give someone money for free, that is a transfer. I would prefer not to give transfers to those who bought bad debt per se, but again, that is a matter for politicians to decide, not the central bank.

In reality, what is happening here is a bailout of wealthy individuals -- investment banks and hedge funds that can unload non-performing debt onto the ECB for an above market price. It seems if we are to spend money this way, the europeans should get something for it -- say a new road or better healthcare.

But the irony of endless EMU bailouts for asset holders while the IMF and EMU force governments to cut pensions and unemployment benefits is not lost on the public.

[Nick Rowe]

RSJ: "That is called fiscal policy." If the bonds are government bonds, then by your definition, *all* monetary policy is fiscal policy. What do you think happens to the seigniorage profits the Bank of Canada earns (the interest it earns from the government bonds it buys in an open market operation)? It gives it back to the government. Over $2 billion a year. What burning the bonds does (maybe) is to precommit its future flow of seigniorage profits to the government.

"Helicopter drops are fiscal policy." They are both monetary and fiscal. A money-financed transfer payment to whoever picks up the cash off the ground.

Who is getting bailed out? the European commercial banks, mostly, plus the Greek government. But they would be bailing them out anyway.

And, if the ECB had not imposed tight money, Greece, and the commercial banks, wouldn't have been in quite this bad a mess in the first place. To what extent is it a "bailout"? Remember, the ability of a country to pay its debts, and the fundamental nominal value of those debts, is not independent of monetary policy.

[Nick Rowe]

Luis: very good article by Vaclav Klaus there.

Andrew: "Surely the ECB can't bail out Ireland, Spain, Portugal, etc. "

Yes it can. Got paper? Got ink? The only question is how much inflation would result. And that depends on how much the current problems of those countries are caused by the disinflationary recession imposed by tight monetary policy. And that's a lot, or maybe all in some cases. Ireland and Spain, IIRC, had low deficits and low debt/GDP ratios before the recession.

[Determinant]

I'm with you Nick, but do you care to explain why the monetary/fiscal authorities who know this are afraid to press the start button on the Euro-printing machine?

Why does it seem whenever we discuss a central bank or government that should be running an outright inflationary policy they aren't?

Why does inflation-phobia seem to win so much of the time?

[RSJ]

"What do you think happens to the seigniorage profits the Bank of Canada earns"

Canada gets seignorage because it is a printer. Greece is not a printer. I think Greece should leave the euro and become a printer. In the process, it should force-convert its debts to drachmas.

But until it does that, I don't think the ECB should be engaging in covert fiscal policy while pressuring Greece to cut its deficit spending and to cut pensions and wages for its own people.

To the degree that any transfers occur, they should be done openly, in which case we can weigh the benefits of who gets the transfer and who doesn't. A helicopter drop is at least fair, if done randomly. Discreetly shoving money into the pockets of banks, while forcing Greece to raise consumption taxes and fire workers is not fair.

What would benefit Greece is if the ECB bought Greek debt directly from the Greek government. But by using the secondary market, but paying above market prices, they are effectively shielding investors from recognizing losses. Although Greece does obtain a benefit, the investors who allocated capital poorly get seignorage off of the benefit. That's what I don't like. If you engage in a secondary market transaction, it needs to be at the market price.

[Nick Rowe]

Determinant: Well, that's the big blogosphere question of the week, isn't it? All the big bloggers have had a go at it. None totally convincingly, IMHO. "Dunno" is my short answer. My mis-coordination post was a longer attempt. "National politics" might be another answer for the Eurozone. What Germans want and what Greeks want may be different.

RSJ: OK. We are on very much the same page. But again, Eurozone national politcs might prevent your proposal. Germans would rather ECB seigniorage go to bail out German banks than the Greek government.

"If you engage in a secondary market transaction, it needs to be at the market price." Remember though, the market price depends on how much the ECB buys.

[Andrew F]

By 'surely the ECB can't bail out Spain, Portugal, Ireland, etc.', I mean, it is not politically expedient or fair for ECB to transfer all that wealth to these countries. They failed to run tight ships, and would be rewarded for it. The only easing that would make sense to me is to buy government bonds from each country on a per capita basis. And that would involve enormous inflationary pressure.

Maybe Europe needs the inflaton, though. Their labour market is far too inflexible.

[Nick Rowe]

Andrew: If loosening monetary policy gets the Eurozone out of a recession, it won't be a *transfer* of wealth, it will be the *creation* of wealth. GDP will be higher.

Also, at least some of those countries *were* running fairly tight ships. The ECB got, or allowed them to get (Scott Sumnerian sins of commission or omission?) into this mess by allowing the recession.

But I recognise you still have a point. Relative to other countries, they ran looser ships, ex post. And that's the trouble with 16 independent nations (?) sharing one money.

[Patrick]

" Their labour market is far too inflexible"

Nobody is that flexible. Look at the horrific state of Latvia and Estonia. Unemployment in Spain is 20%. What more can they do? Deflation/internal devaluation isn't making them more competitive, it's just wrecking the economy and deflating them back to the stone age.

[Qc]

Nick Rowe,
When the ECB buys Greek bonds, where is this money being parked at the end of the day? You have to follow the money... I see three options:
1) this money is parked as deposit at the ECB at 0.25% (this is the rate ECB currently pay on deposit)
2) this money is mopped up by the issuance of German or French bonds (in this case ECB action is equivalent to an asset swap between Greek and German/French bonds)
3) ECB used term deposit facility to mop up the excess money (this is equivalent to 1) except that the deposit facility is temporary).

I don't understand economist's obsession with money supply. Central Banks have long ago stopped targeting money supply as a policy tool, they now focus on the price of money (interest rate). When ECB buys Greek bonds, it does not have a target in term of "money supply", it must however have a target in term of yields on Greek bonds (i.e. set the price at which it is willing to pay for Greek bonds). Judging from the fact that 10-year Greek bonds have recently stabilised around 7-8%, I must conclude that ECB has a "target" interest rate of around 7-8% in term of yields on Greek bonds.

Qc

[Panayotis]

The ECb is not concerned about the Greek people and their economic condition. It purchases state bonds (not only Greek bonds) in secondary markets at above market prices for only one reason. To protect commercial banks as an analysis of this action will tell you.Furthermore, do not forget that the ECB has a substantial portfolio of state bonds via its repo agreements which is facing the same probability of default, if the banks claim inability to purchase them back!
If the ECB was concerned about European citizens it would have supported a debt restructure (reschedule,pricipal discount/rate reduction) without insisting on austerity measures.Given, that the ECB and the EMU is consolidating its policies with more restrictive measures, it is optimal for Greece to reinstate the drachma and denominate all debt in drachmas as I have proposed some time ago in comments in this blog!MMT is right about the advantages for fiscal policy a regime of fiat nonconverible currency with flexible exchange rates.

[Nick Rowe]

Qc: "Central Banks have long ago stopped targeting money supply as a policy tool, they now focus on the price of money (interest rate)."

That is not what central banks do. That is how central banks describe what they do, and encourage other people to think about what they do. There is a very big difference. Central banks suffer from false consciousness.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/interest-rate-targeting-as-a-social-construction.html

[Nick Rowe]

Panayotis: Yes. It would have been optimal for Greece never to have joined the Euro in the first place. Or for the Euro never to have existed in the first place. Given where we are now, it might still be optimal (but very difficult in the transition) for Greece to leave the Euro. It may inevitably leave the Euro anyway.

In this post I am looking for third best solutions, assuming the Euro as given.

MMT? Add a load of other people, from Milton Friedman onwards. But yes, the MMTers are basically right on this, along with others.

[Scott Sumner]

Nick, I've never bought the Krugman argument that central banks might be unable to inflate because their promises wouldn't be credible. If that were really a problem, ought there not be at least one example in the last 13 billion years since the creation of the universe where a central bank promised to create higher inflation and failed? Instead, all I see with the Fed, ECB, and BOJ is central banks saying they won't promise to create inflation because it would be unwise. But when FDR promised inflation he succeeded. One to zero, that's enough to win in soccer, isn't it?

As James Hamilton said in 2008; "Can't create inflation? Put me in charge and I'll show you how." (Or something to that effect.)

Burning bonds seems wasteful. How much would it cost to hire the Zimbabwean FOMC to do a visiting stint at the Fed? Might that create some "expectations?"

Or how about a currency reform? Announce that on July 1st first all old dollar bills would be converted into $10 worth of new bills. How would that change expectations? (I'd actually prefer $1.08, as that's how far NGDP fell below trend.)

[Declan]

Good post Nick, the first two paragraphs in particular, I found helpful. Although I do agree with Panayotis about the ECB's motivations, the motivation doesn't change the effect.

If it makes you feel any better, I have the same problem forgetting that I have already written posts on a given topic.

[Nick Rowe]

In FDR's day, people thought of monetary policy as setting the price of gold. So by raising the price of gold FDR could loosen monetary policy, and be seen to do so. The price of gold is a nominal variable, and has the units $. It moves in the same direction in the short run as in the long run, when monetary policy is loosened. (And I've learned a lot from reading you on this history).

Nowadays, people think of monetary policy as setting the nominal rate of interest ("It is, it is!"). And, "When the nominal rate of interest is at 0%, you can't loosen it any more, obviously!". The nominal rate of interest is not really a nominal variable; it is the rate of change of a nominal variable. It has the units 1/time. It moves in the opposite direction in the short run than in the long run, when monetary policy is loosened.

Sorry. You know all this of course, Scott. I'm just repeating it for other readers.

But it does sort of mean we are in a totally novel situation. It's not at all novel in any objective way at all. But maybe it's totally novel in how people think about the situation. And what tools the central banks think they have at their disposal. And how people and central banks think about what is doable can matter. Our "interest rate fetters" bind our minds just as surely as the old "gold fetters".

[Nick Rowe]

Oh, and burning bonds isn't wasteful. It's just a transfer of resources.

I'm not sure about a currency reform. If the new focal point is just 10 times the old focal point, nothing real will have changed.

Declan: Thanks! Panayotis may be right about the ECB motivation. I don't want to even try to figure it out. If you looked inside their heads, you might just find some bureaucratic mumble.

[RSJ]

Scott, I think the issue here is that under the current constitution, only Congress can convert $1 into $1.08 -- e.g. mail people a check for $.08 for every dollar that they hold. Only congress can do a helicopter drop.

I don't think anyone disputes that congress, by spending money -- whether that money is to buy stuff, or just give away to households -- can cause inflation. But it requires FDR -- backed by a willing Congress. Not the unelected Ben Bernanke, who is bound by the Federal Reserve Act and the Treasury Accord.

And that is Krugman's point, too -- the purchase of riskless liquid assets at market prices -- which is all that the central bank is allowed to do -- will not create inflation in a liquidity trap, but helicopter drops and purchase of goods will. But you need the executive and legislative branches for that.

All these other other ideas -- purchase of stocks or futures -- are just illegal. The Fed can only purchase securities guaranteed by the full faith and credit of the united states government. And to change that would require -- you guessed it -- an act of congress, signed by the president.

[Min]

"One way for a central bank to credibly commit to increasing the money supply permanently is to increase the money supply by buying bonds, then publicly burn the bonds."

Brilliant! :)

[RSJ]

""One way for a central bank to credibly commit to increasing the money supply permanently is to increase the money supply by buying bonds, then publicly burn the bonds."

What would be the point of that? The income received from those bonds is turned over to the Treasury anyways -- well after paying the salaries of the bank staff.

[Determinant]

Dateline: Washington DC.

The Treasury Department has just announced that an in-house review has revealed that Federal Reserve is not doing it's job. Treasury officials have said that Fed has proven unable to credibly provide increased inflation. As an efficiency measure, central banking services to the United States have been contracted out to the Bank of Zimbabwe.

Treasury officials stated "It just wasn't cost effective shovelling all that debt at the Fed and not getting any inflation in return. It's almost as if they wanted to give the bonds back to us! Next thing you know they'll expect us to actually repay them. We just couldn't tolerate that. As a result central banking has been outsourced to the Inflation Wizards of Harare.

Treasury officials have assured Congress that specific performance targets have been written into the contract. Americans must be able to wallpaper their bathrooms with $100 bills by Christmas or the Bank of Zimbabwe will face a Z$10 Trillion penalty per day for each day that the price of wallpaper exceeds that of a C-note.

Treasury officials indicate that the Federal Reserve Bank of New York will now become a branch of the Bank of Zimbabwe. Residents of lower Manhattan are advised to remain outdoors in order to receive their windfall (literally) as the printing presses are ramped up. Airline traffic has been diverted from New York in order to accommodate the amount of currency being ejected from the Fed building.

[Jon]

"The" Fed is backed by the commercial banks who comprise the Federal Reserve system. Every commercial bank is issued shares, the holding of which is required by law. Those shares pay a dividend which is proportionate to bank assets and was intended to cover the 'cost' of holding reserves--something to keep in mind while reading some of the justifications for paying interest on reserves!

The member banks are required to maintain the capital of the Federal Reserve bank at a level equivalent to three-percent of all member assets.

So, I disagree strongly, its not a question of the Fed being bailed-out by the solvent? government. The Fed must by law be bailed-out by the commercial banks if losses on toxic assets deplete its capital.

Therefore nothing about gambling on toxic assets is intrinsically permanent.

[Mike Sproul]

Nick:

"Helicopter money is a permanent un-backed increase in the monetary base. Burning the bonds burns the backing, and so burns the vacuum cleaner that might suck the money back up in future."

Assume for a moment that the backing theory is right, so an increase in the money supply, matched by an equal increase in central bank assets, does not cause inflation. In that case, the REAL money supply increases. Assuming money had been tight to begin with, we'd have reason to believe that the new money would relieve the tight money condition and revive economic activity.

But if the central bank destroys its newly-acquired assets, then a 10% increase in the money supply will result in a 10% increase in prices. The real money supply would be unaffected. There would be no relief of the tight money condition, and no revival of economic activity.

[Jon]

three-percent of all member assets capital, which is about 0.15% of all assets.

[Mike Sproul]

I should add that the above is true if the central bank is completely independent of the government. But if the central bank is really just a branch of the government, then issuing 100 new dollars (which are the government's liability) while destroying $100 of bonds (which are also the government's liability) just replaces one liability with another, and would have no effect on prices (on backing theory principles, that is).

[RSJ]

That's interesting Jon, but I believe -- correct me if I am wrong -- that the "shares" of each Federal Reserve bank have a dividend payment mandated by law. Where does the money come from? From the interest on bonds held by the Fed, net of operating expenses. The Fed pays it's own staff and operating expenses, and then pays interest on reserves, and then pays the dividend, and the remainder is seignorage for the Treasury.

So any Fed losses will come out of Treasury seignorage, but by law the member banks will always get their (generous) dividend coupons, as well as their interest payments on reserves. I don't think that there is a legal mechanism to "absorb" losses by withholding dividend payments -- do you know if there is?

[Andrew F]

Nick:

"Also, at least some of those countries *were* running fairly tight ships. The ECB got, or allowed them to get (Scott Sumnerian sins of commission or omission?) into this mess by allowing the recession.

But I recognise you still have a point. Relative to other countries, they ran looser ships, ex post. And that's the trouble with 16 independent nations (?) sharing one money."

So the issue is managing different economies in a monetary union with no fiscal union. Some might be running too hot and others too cold, while the central bank is targeting an aggregate inflation rate/etc. How to address this then? Variable fiscal policies in each country to adjust for relative (dis)inflationary pressure relative to the aggregate. How has it been implemented? Looks like they went with a tight central bank policy, targeting low inflation, resulting in some countries seeing deflationary pressure. The solution to that is the use fiscal stimulus and rack up government debt. It now seems obvious that this was the wrong approach.

Maybe a better approach would be to run a looser interest rate policy and have the hotter economies use tax or spending policies to slow their economies by increasing their fiscal balance and either repay debt or build sovereign wealth funds. Perhaps each country could have their own 'Central Bank' that uses consumption tax as their policy mechanism, changing rates every 6 months as needed. Rates probably need not change frequently or by much, since they would need to change in accordance with change in economic conditions relative to the rest of Europe, with ECB responding to aggregate changes. It would require serious institution-building to create such a system that had any discipline, being taking the budget balance out of the hands of politicians, so if they raise spending, taxes would immediately need to rise in an offsetting fashion.

Just an idea.

"Nobody is that flexible. Look at the horrific state of Latvia and Estonia. Unemployment in Spain is 20%. What more can they do? Deflation/internal devaluation isn't making them more competitive, it's just wrecking the economy and deflating them back to the stone age."

Point taken, but unemployment is at least somewhat a result of inflexible labour laws. It might also explain some of the deflationary pressure, since it would tend to retard economic activity.

[Andrew F]

I meant to add that had Ireland tried to slow their economy using fiscal policy, perhaps they would not have had such an asset bubble develop, and would not be in the same situation they are now. They certainly would have much lower debt at the moment.

[Jon]

So any Fed losses will come out of Treasury seignorage, but by law the member banks will always get their (generous) dividend coupons, as well as their interest payments on reserves.

The dividends must be paid, but I don't think I'd call them generous. I'd guesstimate that they amount to 2-3% return on required reserves...

[a]

"Especially if they have to come up with cold, hard, tax increases to bail out the ECB and buy back the cash."

they can pay the ECB with newly issued bonds

[Luis H Arroyo]

The ECB should regard himself the Lender of Last Resort of the entire Euro zone. But I'm afraid that it can not.
He is pursuing conflicting goals.
On the one hand, he is mandated to buy debt Greek and Spanish (whith the public objection of Germany); on the other hand, the injected funds are sterilized by the ECB.
Banks are so anxious for liquidity that they deposit money at interest rate of 0.25%, although that cost them 1%. The eurolibor has risen to 0.70%. Recently, It has announce the dissembleming of special operation to face the crisis...
It seems me that there are two conflicting goals: to maintain sovereign bond markets, but without increasing liquidity. Is the risk inflation? I don´t think so: deflation is expected in Greece, Portugal, Spain and Ireland, due to the huge contraction expected because of the fiscal reduction.
More generally: Are we facing the risk of a double dip banking crisis? the signs of distress can be saw also in US interbank market (see the LIBOR-OISS in: http://johnbtaylorsblog.blogspot.com/2010/05/feds-swap-loans-and-libor-ois-spread.html).

[Nick Rowe]

Mike: Aha! I was wondering if/hoping that you would show up here! Notice I've recognised what I consider to be the grain of truth in the "backing" theory?

On your 12.15am comment: I agree totally. If you consolidate the govt and CB balance sheets, and think of them as a unified entity, then the CB burning the govt bonds makes absolutely no difference. But in the case of the ECB, with one CB, and 16 govts, the case for consolidating their balance sheets seems to be weakest. But that's more of a political judgment on my part.

On your 12.11am: Yes let's assume that the backing theory is right (I assume it's partly right). Then:

"But if the central bank destroys its newly-acquired assets, then a 10% increase in the money supply will result in a 10% increase in prices. The real money supply would be unaffected. There would be no relief of the tight money condition, and no revival of economic activity."

Now, draw what you have just said in {P,Y} space, with an AD and AS curve. What is happening? Here's my guess of what you have drawn: You shifted the AD curve up vertically to double its previous height; and you have a vertical AS curve.

Now, suppose your SRAS curve were not vertical, but upward-sloping (sticky prices). You would get an increase in Y as well as in P. (And if your AS were vertical, how did we ever get into a recession in the first place?)

(Off-topic, slightly: and is your AD curve horizontal, or downward-sloping? If it's downward-sloping, you have already implicitly recognised the Quantity Theory. More generally, you really need to integrate your real Bills analysis of the price level into the AD/AS framework, so you can look at your own theory from another dimension.)

[Nick Rowe]

RSJ: "What would be the point of that [burning the bonds]? The income received from those bonds is turned over to the Treasury anyways -- well after paying the salaries of the bank staff."

You've missed the main point of this post. When the CB wants to reduce the money supply, by an open market sale of bonds, it needs to have bonds it can sell. If it's burned them, it can't sell them, so can't reduce the money supply. (Same if the bonds turn out to be worthless).

I should have linked to this earlier post of mine. See reason #2 for CBs to have assets: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/10/why-do-central-banks-have-assets.html

[Nick Rowe]

Jon: I didn't know that about the Fed. Wow! The US really is a foreign country! Who get's the Fed's seigniorage profits?? The Bank of Canada is a Crown Corporation, which means the shares are owned by "HM the Queen of Canada" (really, the government, of course). The government gets the seigniorage profits.

[Nick Rowe]

Andrew: Yes, those are all important problems with the Eurozone, and explain why it got into this mess in the first place.

a: "they can pay the ECB with newly issued bonds". But will they (all 16 of them) willingly do this? Those bonds imply future tax liabilities. And some of the 16 cannot sell bonds at all easily.

Luis: Sounds depressing. As I said in some previous post, nobody seems to have thought much about the lender of last resort function of central banks, when setting up the ECB. And given the lack of a central government, it's not at all clear how, politically, it can fulfill this role.

[a]

"its not a question of the Fed being bailed-out by the solvent? government. The Fed must by law be bailed-out by the commercial banks if losses on toxic assets deplete its capital."

No. The requirement from the commercial banks is only for paid-in capital - not for recapitalization in case of insolvency. The government is the one that bails out the Fed in that case. Total capital = paid in + surplus or - deficit. Paid in capital remains the same and the government covers the deficit.

[The Money Demand Blog]

There is so much confusion about ECB I have written a full post about it. In fact ECB is not sterilising the purchases of Greek bonds:
http://themoneydemand.blogspot.com/2010/06/four-myths-about-european-central-bank.html

Nick, you said:
"Paying interest on reserves is equivalent to the ECB issuing bonds. Issuing bonds doesn't change the net worth of the ECB. But nevertheless, you have a good criticism here. The NPV of a central bank is much greater than the assets on its balance sheet. It's the NPV of all future seigniorage. In other words, it might have to buy an awful lot of really junk bonds in order to trash its balance sheet sufficiently. Hmmm."
And the real inflatonary trigger is a run on a central bank. Commercial banks are regulated by CB, so they cannot run. Only EU member states (e.g. Germany) can quit the ECB by creating a separate currency.

[JP Koning]

"Burning the bonds burns..."

The Federal Reserve Act specifically prevents any portion of the Fed's note issue going uncollateralized (Section 16), thereby heading off anyone with the odd idea of burning collateral bonds from carrying out such a plot. But I'm sure the Reserve Bank of Zimbabwe would let you do it.

"Why it's a really good thing that the ECB has overpaid for Greek junk bonds"

You're prescribing as a cure the very poison that helped cause the whole problem. The ECB has been overpaying for Greek bonds since 2001 by applying the same haircut to discounts of German national debt as Greek national debt. They are not the same credit risk, never have been. This policy effectively subsidized the Greek government's huge debt issues and gave Greek bureaucrats a veneer of credibility they never deserved.

"It's pointless looking at the rules..."

What rules specifically has the ECB broken?

[Nick Rowe]

TMDB: I left a comment on your good post. I'm trying to understand what a "run" on a central bank means. I can understand what it means if the CB promises to redeem its notes for gold or foreign currency, under the gold standard or unilateral fixed exchange rate. But I don't understand it otherwise. What's it a run out of and into?

[Nick Rowe]

Do you just mean a fall in demand for the ECB's base money? If so, that's exactly what I had in mind in this post. At sometime in the future, when the demand for ECB notes falls, the ECB cannot buy them back. So the result is an excess supply of its liabilities, and a higher price level. The anticipation of which is just what the doctor ordered.

[Nick Rowe]

JP: "You're prescribing as a cure the very poison that helped cause the whole problem."

Yep. First rule of dealing with a financial crisis since 18??. Some hair of the dog, so the hangover doesn't kill the patient.

I thought the ECB wasn't allowed to buy government bonds outright. It could only use them for collateralised lending (repos) to commercial banks?

[The Money Demand Blog]

In the context of Eurozone, a run on ECB is when people demand liabilities of German commercial banks in exchange of ECB liabilities in an anticipation of an Eurozone breakup. This isn't what the doctor ordered. People will start anticipating deflation everywhere except Germany. This will be reversed at the unknown moment in the future when Germany quits, generating inflation that is too high in the rest of Eurozone.

[RSJ]

" When the CB wants to reduce the money supply, by an open market sale of bonds, it needs to have bonds it can sell."

OK, this is where the specific institutional arrangements come in. In the U.S., the CB is not allowed to burn bonds, but an "abstract" CB might be, however the abstract CB could also create its own bonds -- just IOUs, right -- and sell them into the market, draining the money supply. As the issuer of currency, those bonds would be risk free.

Also, if the government ran a surplus (e.g. taxed more than it spent), then the monetary base could be reduced via fiscal policy in an "abstract" government. In our specific case, the government would use the surplus to buy back bonds -- reducing the stock of bonds, but not money. But the surplus could just as well be used to reduce the stock of cash and not that of bonds.

The point is that the CB never loses its discretion to add or subtract from the size of the monetary base, and indeed it cannot, because the CB has committed itself to letting the commercial banks determine the size of the monetary base, while it determines the marginal cost of reserves.

[JP Koning]

Central banks causing crisis since 18?? with x, trying to cure them with x, only to cause the same crisis all over again. What a sad story.

The outright purchases are the ECB's nuclear option we talked about in previous posts. As long as they are done on the open market, they do not break the ECB's rules. If the ECB had bought or lent directly to a government, it would be breaking the prohibition on monetary financing. But it is not doing this.

The outright purchases, while legal, are controversial because they go against the grain of the ECB's adopted policy of extending its liabilities solely through short term refinancing operations; collateralized lending. Government debt has been accepted as collateral in these operations. Now the ECB is purchasing and bringing this debt directly onto its balance sheet. Was this sudden u-turn an independent decision made by the ECB governing council, or did they give into political pressure? If the ECB's independence been compromised, then its no more than a crappy banana-republic central bank.

I know you think its pointless to look at rules; after all they inhibit your flights of monetary imagination. But the rules are vital.

[David Pearson]

Nick,

You assume a permanent injection creates not only inflation but growth. This is a critical assumption and you do not take into account the tail risk associated with this dynamic.

If the ECB bought and burned all PIIGS bonds the PIIGS countries would no longer have a solvency problem. However, they would still need financing for a now-smaller primary deficit. At what price would the markets finance that deficit? Given the likely devaluation caused by the ECB bail out, markets would demand a steep sovereign premium. This, in turn, would increase the PIIGS deficits, which in turn might make markets demand an even higher premium, causing an adverse positive feedback loop. Faced with that loop, the ECB would likely step in to buy and burn more bonds. What this is called is permanent monetization of structural fiscal deficits. The risk of this dynamic is what typically sends velocity through the roof as markets attempt to hedge future inflation/devaluation. The result can be hyperinflation, as we have seen in various Latin American countries.

Of course, if real growth eliminates the need for fiscal deficits, the ECB could pat itself on the back for a job well done. This might be the mid point of a forecast probability distribution. It is in no way reflective of tail risk.

Should monetary policy be formulated in the context of avoiding tail risk?

[Mike Sproul]

Nick:

"you really need to integrate your real Bills analysis of the price level into the AD/AS framework, so you can look at your own theory from another dimension"

That sounds like the real sticking point. I haven't made this clear before, but I don't see even a grain of truth in the AD/AS model. From my point of view, trying to integrate the RBD into Keynesian theory is like trying to integrate astronomy into astrology.

The RBD, while inconsistent with textbook macro theory, is consistent with classical price theory. In particular, the RBD says that money is valued according to its backing, just like any other financial security.

[Jon]

Nick: as I mentioned, the dividend payments are quite small. "by agreement" the Fed pays most of the money to the treasury.

[Panayotis]

JP Koning,

You are making an important point about rules. However, remember that rules are made and broken when they violate the primary objective of the institution. In this case is the financial stability of the EMU banking sector. This is what motivates them to break thie existing rules!

As far as the difference between ST refinancing operations and purchases in secondary markets is concerned, there is no difference if the banks fail to honor their repo obligations because of economic conditions and the capital erosion from the value of these securities(when you buy back your capital is eroded from mark to secondary market revals. Then the lender of last resort principle will come into play!

[jj]

"...any increase in the money supply should be permanent, and perceived as permanent, to do much good."

If AD is threatened to fall because of a drop in velocity, then money supply could be temporarily increased to maintain a constant MV. When V increases then M could be reduced.

In other words, a temporary increase in money supply would be effective.

[Luis H Arroyo]

"Luis: Sounds depressing. As I said in some previous post, nobody seems to have thought much about the lender of last resort function of central banks, when setting up the ECB. And given the lack of a central government, it's not at all clear how, politically, it can fulfill this role."
Nick, that is completly truth.
On the other hand, much seem to forget that "Monsieur" Trichet was the only cntral banker that rise the interest rate in 2008, just before the cataclysm triggered by Lehman failure.
Is the ECB an independent central bank, or a banana republic´s one? I think that, following what I've read in Nick's, it is neither one thing nor the other, but something worse, because not having a government, but 16, against who defend their positions, there is not a power alternative face to which defend their independence. Its Council decides always by unanimity.
The ECB is defined as responsible to the European parliament; but the Euro parliament is a fictitious institution, which represents no one.
if you think about it, is an entity that has never existed in the past. A product of bureaucratic engineering, which has no other criterion that its statutes, very anti-inflation biased. A perfect example of too much independence?
or perhaps an example of supreme hectoplasma?
An historic mistake, in any case.

[Nick Rowe]

Sorry for wandering off my own topic, but I've been thinking about Mike Sproul's comment above.

Mike: you don't have to be a Keynesian to think of AD/AS. And any theory ought to have some sort of representation in {P,Y} space.

Suppose you halve M, while holding backing constant, or double the backing, while holding M constant. P should halve, right? What happens to Y? If it's neutral, then all real variables, like Y, should stay the same. OK, so you are tracing out points along a vertical curve in {P,Y} space. Call it the "AS" curve. Now, what would happen if you assumed that prices of goods and services were sticky. Take an extreme case, suppose they are fixed by law, so P cannot halve. What happens to Y, according to the RBD?

Next question: suppose you hold M, and backing, constant. Suppose all resources (labour, Kapital, Land, etc.) double. So Y doubles. What happens to P? If nothing, then you are tracing out a horizontal curve. Call it an AD curve.

All asset prices are determined by demand and supply. This does not contradict RBD, which is just a theory of demand for assets. But there must be some version of something like Walras' Law in your model. There must be some relation between an excess demand or supply for money, and an excess supply or demand for goods.

1/P is the price of money in terms of goods. P is the price of goods in terms of money. If the former is determined by the supply and demand for money, the latter must be determined by the supply and demand for goods, and those two sets of supplies and demands must be related somehow.

[Nick Rowe]

David: "Given the likely devaluation caused by the ECB bail out, markets would demand a steep sovereign premium. This, in turn, would increase the PIIGS deficits, which in turn might make markets demand an even higher premium, causing an adverse positive feedback loop."

I disagree. Markets, if rational, should calculate the deficit as the primary deficit plus the *real* interest rate on the debt. They should ignore the inflation premium.

[Nick Rowe]

TMDB: "In the context of Eurozone, a run on ECB is when people demand liabilities of German commercial banks in exchange of ECB liabilities in an anticipation of an Eurozone breakup."

Interesting. I hadn't thought of that. And presumably people would do this expecting Euro deposits at German banks to be converted into Neu Deutsch Marks? But the ECB is not obliged to redeem its notes for liabilities of the German commercial banks.

BTW, I just enrolled your blog in the Palgrave Economics Blog roll.

http://www.econolog.net/index.php

[David Pearson]

Nick,

I meant a real premium. While governments can print and have negative short term real rates, the markets typically extract a steep, real term premium. In extreme cases (i.e., Brazil pre-Cardozo), the premium makes all but ultra-short term borrowing prohibitive.

I would put this question to you another way. If you were a Euro bond holder and saw the currency depreciate after an ECB "buy-and-burn" operation, would you,

a) sell and move your money to a more stable currency until the real, risk adjusted return on Euro bonds rises considerably
b) say, "its ok, Europe will grow, and they'll never do it again," and buy more

I'm not predicting the outcome, I'm saying that its useful to recognize that hedging behavior can introduce an adverse positive feedback loop, as has happened time and again in Latin America. The question is, should this tail risk be taken into account in setting policy (you can still argue the tail risk doesn't exist, but please explain why choice a) above is highly improbable for market actors)?

[Mike Sproul]

Nick:

This seems like one of those cases where two views are so different as to be mutually unintelligible, but here goes anyway.

"And any theory ought to have some sort of representation in {P,Y} space."

The usual price theory model of general equilibrium doesn't use P,Y space, and it doesn't try to aggregate things that can't be aggregated. I just think of an economy as a community production-possibilities curve (CPPC). If that economy is cash-starved, maybe because of banking regulations, then people are reduced to less efficient means of trade and the CPPC shifts in. If new money is then introduced, trade becomes easier and the CPPC shifts out. If that new money is adequately backed, then money holds its value even though its quantity increases. Keynesians would see M rising with no effect on P and think "sticky prices", but I'd answer that the value of money is not sticky. It's just that that the new money is adequately backed.

"Suppose you halve M, while holding backing constant, or double the backing, while holding M constant. P should halve, right?"

right

"What happens to Y? If it's neutral, then all real variables, like Y, should stay the same."

right

"OK, so you are tracing out points along a vertical curve in {P,Y} space. Call it the "AS" curve."

I could just as well flip a coin all day, plot the number of heads H against Y, and say I've traced out a vertical AS curve in H,Y space

"Now, what would happen if you assumed that prices of goods and services were sticky. Take an extreme case, suppose they are fixed by law, so P cannot halve. What happens to Y, according to the RBD?"

It would be the same if silver were held at twice its equilibrium price by law. There would be a surplus of silver and deadweight losses.

"Next question: suppose you hold M, and backing, constant. Suppose all resources (labour, Kapital, Land, etc.) double. So Y doubles. What happens to P? If nothing, then you are tracing out a horizontal curve. Call it an AD curve."

See the coin flip example.

"All asset prices are determined by demand and supply. This does not contradict RBD, which is just a theory of demand for assets. But there must be some version of something like Walras' Law in your model. There must be some relation between an excess demand or supply for money, and an excess supply or demand for goods."

A stock market example might clarify. Finance prof's don't normally speak of excess demand or supply of IBM stock. They speak of backing. Any stock whose value doesn't reflect backing creates arbitrage opportunities for traders, so they speak of arbitrage conditions rather than supply and demand.

"1/P is the price of money in terms of goods. P is the price of goods in terms of money. If the former is determined by the supply and demand for money, the latter must be determined by the supply and demand for goods, and those two sets of supplies and demands must be related somehow."

The value of money is determined by backing, not supply and demand of money. Supply and demand curves are for actual commodities, produced using scarce resources. Money can be nothing but computer blips. The supply and demand of computer blips does not determine their value.

[Nick Rowe]

Nick's theory of the price of IBM stock:

The price of IBM stock is determined by supply and demand. The demand curve for IBM stock (to a first approximation) is perfectly elastic, given by the forumal P=Present Value (dividends, earnings, whatever).

"I just think of an economy as a community production-possibilities curve (CPPC). If that economy is cash-starved, maybe because of banking regulations, then people are reduced to less efficient means of trade and the CPPC shifts in. If new money is then introduced, trade becomes easier and the CPPC shifts out."

Yep. That's what we Keynesians and Monetarists call a recession, and recovery, caused by the AD curve shifting left, due to a decline in the real money supply, then shifting right again, when the real money supply is increased.

[JP Koning]

Panayotis,
In a society that respects rule of law, and a few of these exist, central bank rules can't be broken for the sake of "primary objectives". Before a central bank can burn its backing, it must get the relevant section of its governing act changed. This is a long process involving senate/parliamentary committees and finally a vote. Only when all these steps are complete and the act been properly amended can the central banker burn his backing.

But you are right that rules are often broken when they violate primary objectives. I'd say this applies in the societies that don't respect the rule of law, and therefore characterizes most African, Asian, South American, and European central banks. The Bank of Canada is better than most in respecting rule of law.

[Mike Sproul]

The supply curve of IBM is also perfectly elastic. If P>PV(dividends, etc) then IBM will issue huge numbers of shares. If P

[Mike Sproul]

Previous comment somehow got chopped off.

If P

[Mike Sproul]

That one got chopped too. I'll try later.

[Mike Sproul]

Educated guess: The comments got chopped when I used a "less than" sign. So once more:

If P "less than" PV(dividends, etc), then IBM will issue no new shares and will buy back old ones. Since S&D are both horizontal at the level determined by backing (equivalently, PV(dividends, etc), share price is determined by backing, not by supply and demand for shares.

[Stephen Gordon]

Sorry you're having troubles. Maybe you could try writing everything as a plain text file and then cut-and-paste into the message field?

[JP Koning]

Regarding runs on central banks.

I'd say that every central bank in the world has been facing at least a low-level run for decades. Because central banks consistently debase their currencies, people "run out" on their bank's circulating liabilities by purchasing other assets.

Many central banks experience medium level runs. In certain transactions (large ones like corporate takeovers, salaries for the elite) the domestic central bank's liabilities cease to be accepted as payment. Partial dollarization is the result.

True runs on central banks occur when even the lowliest retailer refuses to accept the bank's circulating liabilities. This is what occurred in Zimbabwe. The run resulted in Zimbabwe dollars becoming worthless and their spontaneous substitution by rand and US dollars, though not before the decimation of Zimbabwe itself.

[Patrick]

If you use < directly typepad thinks you're opening and HTML tag, so it get's confused. It may get confused by > too. Instead, use &lt; and &gt; (an ampersand followed by lt or gt followed by a semi-colon). More info here

[K]

Nick,

There seem to be two relevant, but unrelated, points in your post.

1) The CB can buy high beta assets.

This, as you point out, is great negative feed back. Ideally, for the sake of fairness, they should be broad indices, as well as high risk premium assets like senior CDO tranches. Buying a portfolio of senior corp/sovereign debt tranches, in particular, would provide support for credit spreads in general without benefitting any individual issuers in particular. It also has the benefit of making money creation permanent in the worst possible circumstance.

2) The CB can overpay for assets.

The ECB was already doing this by repoing Greek bonds with "actuarial" haircuts. Then in the face of downgrades, apparently, they had to suspend even that discount. PPIP is another (though more egregious) example - just a way to give money to a special interest while concealing it from the general public. It's a fraud against the citizens and cannot seriously be advocated as responsible monetary policy.

[The Money Demand Blog]

Nick,

"And presumably people would do this expecting Euro deposits at German banks to be converted into Neu Deutsch Marks? But the ECB is not obliged to redeem its notes for liabilities of the German commercial banks."
Yes, the expectation is that Euro deposits at German banks and German bonds will be converted into new DM. ECB is not obliged to redeem its notes for liabilities of the German banks. But ECB needs that Germany accepts ECB liabilities as a payment for German bonds. At this moment Germany is collecting premiums for this, as market rate on one week ECB deposits is equal to the yield of 1 year German bonds.

"BTW, I just enrolled your blog in the Palgrave Economics Blog roll."
Thanks.

[Nick Rowe]

K: good points. I like your "high beta" way of thinking about it. I expect that when I said "overpay", I should have said "paid more than what the fundamental value would have been if the ECB hadn't managed, by buying them, to raise that fundamental value, by creating expectations of recovery".

It's a tricky point, defining fair value, when your very act of buying an asset raises its fundamental value. Which will happen, if its a central bank doing the buying.

[The Money Demand Blog]

Let's define the fundamental value as the EMH value conditional on Eurozone inflation expectations being on CB target. I think Trichet is quite careful not to deviate too much above fundamental value so defined.

[Nick Rowe]

TMDB: That makes sense to me.

[BuddhaBuddy]

'Our "interest rate fetters" bind our minds just as surely as the old "gold fetters".'

I feel like I'm back in the sixties, except without the drugs and actually talking about something important...or reading about something important. Great post Nick.

[PierGiorgio Gawronski]

I understand the logic of reducing real interest rates by rising expectations of future inflation. Thus, burning ECB/FED assets on the public square would make the increase in money supply permanent, and ad credibility to a policy of (future) higher inflation. But there is much more that that in my proposal. For Central banks can always reduce M if they want (increasing bank reserves is one way). Also, see Posen on Japan: the lesson he draws is that monetary policy is a very weak tool especially at the zero bound, no matter how much quantitative easing you do. So Krugman is right to say that we should rely mainly on fiscal policy. But he adds: "until it is possible", meaning until debts are not too large. Burning Gov Bonds in the public square signals to the markets an fiscal autorities that the gov solvency equation (constraint) is being relaxed, and there is more room for fiscal expansion.
So Nick I think your idea of raising expected inflation is nice, subtle, correct. But weak. Academically nice, but we need more. Fiscal policy money financed, is much more dirct and powerful. Regards.