The ECB's internal contradictions

The Eurozone news is really depressing. I think things are going to be very bad very soon. I don't have much to say that I haven't already said in previous posts. But thought I would add this anyway, FWIW.

The ECB doesn't like inflation uncertainty; it wants to keep inflation predictable and just below 2%. The ECB doesn't like buying the bonds of Eurozone governments. The ECB, presumably, wants to preserve the Euro and preserve its own existence.

Everything the ECB is currently doing seems almost designed to lead to the exact opposite of what it wants.

The ECB is currently buying limited quantities of Eurozone government bonds. But it has made no public commitment, conditional or otherwise, to do so in future. It doesn't want to buy more.

Suppose the ECB made a very public commitment to buy unlimited quantities of the bonds of any Eurozone government, if ever the interest rate on those bonds rose above (say) 5%, conditional on "good behaviour" of those Eurozone governments. If it did that, and also loosened monetary policy more generally, most Eurozone governments would be able to get back to solvency, their bonds would become safe liquid assets, and their bond yields would fall below 5%. (Greece might be an exception). By promising to buy the bonds in unlimited quantities if necessary, the ECB would most likely have to buy none. It could even start selling the bonds it already owns, if it wanted to. (Readers may recognise Chuck Norris making a guest appearance in this post).

[Update: see Edward Harrison on this same issue. Edward goes into much greater depth than I can manage.]

Given the current ECB policy, what will be the value of the Euro, in terms of goods and services, in (say) two years time? What is the likelihood that it will be anywhere close to 4% ( 2 years x 2% inflation) less than it is today? Very small, in my opinion. If the crisis continues, but by some miracle the Eurozone hangs together, the most likely result will be deflation. If the Eurozone breaks up, many existing Euros will be converted into successor currencies that will depreciate. If the breakup is total, the Euro might even become worthless.

Under the existing ECB policy, I'm very uncertain about the future value of the Euro. I'm not even exactly sure how to define the question, when we start talking about successor currencies. If the ECB loosened monetary policy, and also acted as lender of last resort by making a public conditional commitment, the future value of the Euro would be much more predictable, and much closer to the inflation target.

Under the existing ECB policy, the Eurozone is coming apart. If the ECB loosened monetary policy, and acted as lender of last resort, it might continue to exist. (Or, at least, allow for a more orderly breakup, which I think would be the better option, though a disorderly breakup is more likely).

The ECB is doing everything it doesn't want to do. If you want to go forward, but there's a cliff in front of you, it's best to go backwards and around.

Comments

[Ralph Musgrave]

The ECB “promising to buy the bonds in unlimited quantities if necessary..” equals a subsidy of the periphery by the core. That is a big step to take. Subsidising other countries was not one of the conditions on which core counties entered the EZ. So the above “subsidy” decision is a POLITICAL decision.

Or as Mervyn King put it, that is a decision for governments not central banks, like the ECB. See Mervyn King’s views here:

http://www.guardian.co.uk/business/2011/nov/16/mervyn-king-defends-ecb?INTCMP=SRCH

As to Chuck Norris, I don't have a huge amount of faith in him, nor I suspect do the markets.

[Nick Rowe]

Ralph: it is indeed political. But the paradox is that the actual subsidy would very probably be much less, or even eliminated, if you made an explicit conditional commitment to subsidise.

Hundreds of years of history of central banks acting as lenders of last resort in a crisis says you are wrong about Chuck Norris. The Bank of England has always gone Chuck, in an emergency. And once the markets see Chuck is serious, the bears run away.

[Donald Pretari]

I agree with everything you said, but could you switch from Chuck Norris to Jet Li?

[David Pearson]

Nick,
"And once the markets see Chuck is serious, the bears run away."

The likely outcome of any macro policy prescription/projection is a state of the world that can be expressed by a portfolio of contingent claims on three idealized assets (gold, 30yr Treasuries or Bunds, stocks). Today, the bears believe that the Fed/ECB must either be ineffective (deflation) or irresponsible (high inflation). Their portfolio is long 30yr calls/long gold calls. This is the true "anti-Chuck"bear bet.

The "bulls" (you!) would be long S&P500 calls/long 30yr or gold puts. You believe monetary policy can produce a real recovery without unanchoring inflation expectations.

Would an ECB rate ceiling scare me out of my bear portfolio? No. It might help Italy a bit, but only if it produces inflation (which Italy desperately needs). If it produces inflaiton, I don't think the ECB can control it since returning to positive real rates is next to impossible without blowing up Italy again.

[david stinson]

It strikes me that are (at least) four issues in Europe: a) tight money in the PIIGS; b) sovereign profligacy/moral hazard, c) malinvestments, and d) sovereign insolvency due, depending on the country, to a) and/or b).

Notionally, I suppose, the defaults address the malinvestments.

Why would it not be possible or desirable to address the other issues by having the ECB purchase: i) all PIIGS’ sovereign and national central bank gold (and perhaps their other foreign currency?) holdings, and ii) the rights to the future net receipts of planned privatization. The funds received from these sales to the ECB could, perhaps in a process administered by the ECB, be used to redeem that amount of sovereign debt necessary to reduce the total debt (remaining after agreed upon defaults) to sustainable levels. I gather that the value of sovereign property and assets that could be privatized is substantial. ECB advance purchase of the privatization receipts would permit the privatization to proceed at a revenue-maximizing pace rather than on a “fire sale” basis. ECB purchase of hard assets would, in addition to accommodating temporarily high demand for money, satisfy concerns about reversibility of monetary expansion and the creation of moral hazard and be self-liquidating in the case of the privatization receipts.

[Mandos]

I am, um, kind of on the ground here at the moment having had an opportunity to chat with informed "lay" people from some of the countries affected (on both sides of the inflation fence), and the actual popular complacency is unbelievable.

[JKH]

In the match of George Soros versus the Bank of England, who played the role of Chuck?

[david stinson]

" In the match of George Soros versus the Bank of England, who played the role of Chuck?"

Sweet.

I guess central banks really only have unquestioned credibility in one direction.

[JKH]

All potential solutions – ECB, EFSF, IMF – are political.

But the potential ECB solution has enormous technocratic advantages that the others don’t.

The ECB can guarantee solvency if it wants – simply by purchasing the bonds at any point of its choosing.

But the second huge advantage is that it can also guarantee the cost of debt servicing if it wants. The ultimate, net cost will only be the interest cost that the ECB pays on newly created reserves. After you get through netting out all the ECB capital costs and profit/loss allocations, etc., that’s all that really matters.

Basically, this works because the ECB dictates the net interest rate cost by forcing it through the banking system and setting the price as a monopolist.

I hate the Chuck Norris metaphor, but if the ECB does enough of this, the private sector will step up and start buying the bonds simply out of greed.

This would work, but it won’t happen.

[JKH]

And the ECB would indeed have to do "enough of this".

A sizable, overpowering show of force would be required.

Promising is not enough.

[Jacques René Giguère]

Profligacy?
Italy's debt to GDP is lower thanin 1995. Remember the 1995 crisis? Me neither. They were using the worthless lira. Still no crisis.
Slovakia's debt to GDP is überMerkellian at 35% of GDP. This morning they couldn't float an issue...
As Yglesias concludes
the europeans soverigns are noe like african countries with no central bank.
http://thinkprogress.org/yglesias/2011/11/15/368474/368474/

[Nick Rowe]

JKH: "In the match of George Soros versus the Bank of England, who played the role of Chuck?"

The Bank of England couldn't print Deutschmarks. The ECB can print unlimited Euros. People want to sell bonds and buy Euros. The ECB can print as many Euros as people want to buy, and buy as many bonds as people want to sell. Forget setting interest rates. It's the ability to print that matters.

[Max]

Maybe everyone is approaching this problem from the wrong angle. Instead of the ECB guaranteeing the bonds of the periphery conditional on deficit reduction, it should guarantee the bonds of the core, conditional on deficit increase.

Subsidize the core and bully them to spend more, rather than subsidize the periphery and bully them to spend less.

[Nick Rowe]

David Pearson: "The "bulls" (you!) would be long S&P500 calls/long 30yr or gold puts. You believe monetary policy can produce a real recovery without unanchoring inflation expectations."

I'm more of a bear. I think the ECB *can* do this, but I'm not optimistic it will.

david stinson: I read somewhere recently on how much gold they have. IIRC, it wasn't really enough. The privatisation of state assets would only help if the new owner could get greater returns on that asset than could the state. It's only the difference (if any) that matters. Maybe it would help, but I'm not sure how much. Dunno about the political repercussions either. Though, given the way the politics is going, with the EU/ECB effectively choosing who the PM and cabinet is.....

Mandos: that's both interesting and surprising. God help them all. My (not very political, not very economist) siblings in the UK seem to be concerned enough, even at a slight distance.

Jacques: yep. It's the "no central bank" bit that matters. Any country that borrows in its own currency and has its own central bank has its own Chuck Norris/Jet Li. What I'm talking about is the ECB doing what any normal central bank would do.

[Nick Rowe]

Max: interesting. Maybe a bit of both. But the only truly core country left at this stage, AFAIK, is Germany. Spreads against Germany are widening everywhere, IIRC.

[David Pearson]

JKH and Nick,
Yes, its easier to devalue than defend a currency, since the latter entail using scarce FX reserves. However, the market "Chuck" can still pull a "Soros" in the case of an ECB Italy rate ceiling:

-Short vast quantities of Italian bonds to the ECB
-Short vast quantities of Euro's

If ECB reserve creation does not produce inflation (i.e. no demand for marginal bank reserves), Italy will ultimately default, paying off the short bond trade.

If ECB reserve creation does produce inflation, the ECB will be powerless to contain it, as raising rates would tank Italy. This would payoff the short Euro's trade.

Of course, you could assume that ECB reserve creation will create much growth and little inflation. That's a big assumption.

[Nick Rowe]

David: assume the worst case - the ECB creates only inflation, and the real primary surplus of the government is unchanged. It's that real primary surplus that is used to pay the bondholders. If the alternative was (say) a 30% default, a 30% inflation would be neutral for bonds, plus, there wouldn't be all the additional costs of a default. Any growth at all, and it should be a net plus for bonds, because the real primary surplus could be higher. The only case that would be negative for bonds would be if there is so much inflation the risk of default dropped to zero.

[David Pearson]

Nick,
If I understand you correctly, you are not allowing for inflation to become a self-reinforcing dynamic. Once markets believe a "short Euro" strategy is a sure thing, they will press it until the ECB proves otherwise. Raising rates would not be a credible threat as it would plunge a good part of Europe into default.

For any policy designer, I would recommend finding a competent speculator and asking them two questions about the policy:
-how would you bet against it?
-could this bet spark a self-reinforcing dynamic if markets gravitated towards it?

[Nick Rowe]

David: yes, I think that's correct. Most cases of hyperinflation that come to mind are where the central bank either couldn't or wouldn't control the money supply, because they couldn't or wouldn't control the deficit. As long as the Eurozone countries can run a primary surplus equal to the debt/GDP ratio times (the real interest rate minus the real growth rate), they can pay down the debt/GDP ratio.

I keep remembering that the UK has had debt/GDP ratios of 200% more than once.

[David Pearson]

Nick,
Its not just the fiscal deficit. Actors in the private economy get used to low or negative real rates. They borrow accordingly. Jack up real rates, and they get into leverage difficulties and restrain consumption/investment. Financial intermediaries also get hurt, so debt repayment doesn't flow back to productive uses. In the end, central banks find it hard to get from the "point A" of sustained negative real rates to the "point B" of normal, 2% positive real rates without landing the economy back in the soup. Of course, when that happens, the fiscal deficit also suffers.

[edeast]

Did you read the latest kierkegaard? still very much, manic to your depressed. but introduces financial repression to hedge his prediction.

[edeast]

link

[reason]

Nick,
I'm with you on this.

[Nick Rowe]

edeast: The kierkegaard piece is good. There's a lot of really good stuff on the ECB coming out now, from people who are following it much more closely than I can manage.

[Peter]

> conditional on "good behaviour"

I think this is the weakness of the plan. You could still get a run on the debt if the market fears that this conditional might trigger. The ECB would then either end up with all the debt or would have to trigger its "bad behavior" clause.

[Nick Rowe]

Peter: yep. But all plans for saving the Euro, or trying to create a less disorderly breakup, look weak at this stage. It's making the best of a very bad lot.

[Paul Meli]

"Most cases of hyperinflation that come to mind are where the central bank either couldn't or wouldn't control the money supply, because they couldn't or wouldn't control the deficit."

Didn't most cases of hyperinflation also include a collapse in production and/or debt in a foreign currency (or gold)?

[David Pearson]

Paul, I think "hyperinflation" is a loaded term. People associate it with wheelbarrows of money used to pay for bread: something that only happens with the conditions you cite. Before you get to "hyper", you have "high and variable": Brazil, Argentina and most of Latin America in the late 80's/early 90's. Central banks prevent "high and variable" from becoming "hyper" by inducing periodic bouts of austerity along with new currencies. In Argentina, you had the Peso, New Peso, Austral, New Austral, and the dollarized Peso and finally the current Peso. In between, inflation never went "hyper", it just spiked and stayed high.

As for foreign currency debt, it was present but not a precondition: in fact, the governments repeatedly tried to inflate away their local currency debt to relieve their fiscal burden.

[Nick Rowe]

Paul: It takes an awfully big collapse in production *by itself* to cause a big inflation. Theory suggests, for a ballpark, a halving of production should cause a doubling of the price level, not a zillion-fold increase in prices. But if production problems, or debt, cause a government to be unable to finance its deficits, except by printing money, then you can get a hyperinflation.

[Paul Meli]

"Paul: It takes an awfully big collapse in production *by itself* to cause a big inflation."

Agreed but I said "also" meaning that printing money *by itself* is not under normal conditions enough to cause a hyper-inflation.

Weimar? Zimbabwe? I think those two are examples of hyper-inflations caused mainly by sharp contractions in productivity exacerbated by high debt in a foreign currency. Printing money as a desperation response just drove the final nail in the coffin.

I think "printing money" is mentioned too often in the same sentence as hyper-inflation when in fact most episodes of printing money haven't come to that.

Anyway, what do you consider worse, hyper-inflation or deflation.

[Max]

Supply destruction by itself doesn't necessarily cause an increase in the inflation rate, just a one time price increase. Hyperinflation is caused by a government futilely trying to maintain the previous level of real spending.

[Will]

Amusing post title, comrade Rowe. Sadly, the ECB seems dead set on destroying the eurozone. The only hope would seem to be that Hjalmar Horace Greeley Schacht emerges from beyond the grave and somehow takes the helm. Not likely.

Ironically, a decade ago the Germans were the only ones on board for a fiscally integrated, federal European state.

[Peter]

Nick, don't you think NGDP level targeting would be good enough to save the Euro? Perhaps one or two countries would still default, but why would it have to be the end for the Euro? What if they pick a much higher NGDP growth rate, like 10%? High enough to allow for easy internal devaluations.

[Sergei]

"The Bank of England has always gone Chuck, in an emergency"

And then Soros made 2bn. Along with many other guys.

History is full of all types of examples. You can not assume away those you do not like.

[Sergei]

"The Bank of England couldn't print Deutschmarks. The ECB can print unlimited Euros. "

ECB is not buying anything. NCBs buy. Do you assert then that Greek NB can print unlimited German NB liabilities? For how long?

[Nick Rowe]

Peter: "Nick, don't you think NGDP level targeting would be good enough to save the Euro?"

Well, it would sure help. But I really can't decide whether acting as lender of last resort would: help it hit the NGDP target; be unnecessary if monetary policy was good; be a good thing anyway whether or not monetary policy was good. Complements, substitutes, or two independent goods? Dunno.

Segei. I've been trying to follow the argument that Hans Werner Sinn (he was at UWO decades ago, BTW) is making regarding the ability of the the Eurozone national banks to print ECB liabilities. I haven't got my head around it fully.

[Sergei]

Nick, the way eurozone and its payments system is organized and setup is that NCB can go into unlimited and uncollateralized overdraft at the ECB and ECB is just a consolidating entity. So when the Greek CB buys Greek bonds and this easing ends up in additional current account deficit to, say, Germany then effectively German CB is financing it. It all happens behind the scenes but the German CB *is* always a (unwilling) creditor in case noone else wants to take the lifting. And noone wants especially after "they" legalized a 50% theft.

And I do not know what Hans Werner Sinn says.

[Nick Rowe]

Sergei: I *think* that's what H W Sinn is saying too, and he says it has been happening a lot.

Here's a recent example: http://www.voxeu.org/index.php?q=node/7290

People were arguing against him a month or so back, and I never quite got to the bottom of it.

[Sergei]

I had a good laugh. Looks like somebody somewhere told him about something and he is just trying to tell us what he understood and still remembers. This guy is seriously confused.

"Because the printing presses in the periphery are still running at full speed, the Bundesbank has had to turn its own presses into shredding machines in order to destroy the money that has flooded in from the South."

It is exactly the other way around. LOL.

[Nick Rowe]

Sergei: I don't understand that. Here's how I see what he is saying. BMWs flow from Germany to Greece. Euros flow from Greece to Germany to pay for them, so Greek banks lose reserves to German banks. So the Greek National Bank borrows from the Bundesbank so it can lend to Greek banks, and the Bundesbank borrows from the German banks.

Or, if there's a slow bank run, with Greks withdrawing their deposits from Greek banks, and opening accounts in German banks, the two national banks reverse the flow, to keep Greek banks functioning.

[Jacques René Giguère]

Yes Nick. And then BMW goes bankrupt. And the Germans will blame the Greeks. Not themselves.

[Jacques René Giguère]

Some in Germany seem to slowly understand. But they're not Germans.
Jim Reid from Deutsche Bank
"If Merkel doesn't budge,my investment advice is:Dig a hole in the ground and hide."

http://articles.businessinsider.com/2011-11-18/markets/30413861_1_ecb-sovereign-euro

[Sergei]

Nick: Bundesbank borrows from the German banks

Bundesbank can not borrow its own liabilities. No bank can borrow its liabilities.

Your causality is wrong. When BMW sends its cars to Greece, Greek NB runs an overdraft to ECB, Bundesbank runs a positive balance to ECB. One offsets another but effectively Bundesbank is lending money to Greek NB which then on-lends to Greek banks. Therefore in the language of H W Sinn Bundesbank is running printing presses full speed and not shredding machines. And please note that effectively euros do not leave Germany. Greece borrows euros from Germany to send them back to Germany. All happens during a regular intra-day payments period.