What were they thinking?

One of the best lines I heard at this year's CEA meetings was delivered by Chris Ragan, at a session on the Euro organized by Paul Jenkins.

Chris was speaking to a picture of Eurozone bond yields, much like this one that I've lifted from An Economic Sense:

Looking at the convergence between the yields on higher-risk bonds like Greece's, and lower-risk bonds like Germany's, after the introduction of the Euro, Chris Ragan observed, "You look at this picture and ask yourself: What were they thinking? Actually, you can tell what they were thinking. The question is why they were thinking it."

The convergence of bond yields after the Euro was introduced reveals that the pre-Euro yield differences were almost entirely based on inflation and exchange rate risk. No one ever seriously considered the possibility that an EU country might not be able to repay its debt. That's what they were thinking. But as Chris says, the question is: Why? 

Comments

[K]

Frances,

It's an incredible graph!

"The convergence of bond yields after the Euro was introduced reveals that the pre-Euro yield differences were almost entirely based on exchange rate risk."

Since these were domestic currency yields, I don't think you could call it exchange rate risk. The yield is determined by the expected return of buying a bond and financing the purchase by rolling funding at the *domestic* short rate. So it's really policy rate risk, which is driven by inflation risk. Though inflation risk may also produce fx risk, this risk is principally to the extent that higher inflation is *not* offset by higher nominal rates. I.e. fx is exposed to the part of the inflation risk that the domestic bond yield is *not* exposed to. If, for example, the domestic short rate exactly follows expected inflation so the real rate remains unchanged, then there will be little fx volatility, but correspondingly big rate risk for domestic currency bonds.

Inflation, to a global bond investor (rather than the arbitrageur described above), is of course just another word for default. So default risk after looks very much like "default" risk before. The interesting outliers are the UK and Ireland. Very similar yields before, but the UK looks like Germany after. Ireland not so much, though every bit as austerian as the UK.

[Frances Woolley]

K - I originally wrote 'inflation and exchange rate risk' and then took the inflation out. I'll put it back in again, Frances

[Frances Woolley]

K - for a foreign bond holder, inflation risk = exchange rate risk.

[Left Outside]

The divergence post Lehman looks quite small, the divergence after the ECB raised interest rates in July 2008 looks massive.

Too me that says markets were assuming demand management in the Eurozone would be adequate, that rate hike told them it wasn't. Considering nobody knew we were leaving the great moderation, I'm loathe to be as dismissive as Chris. Nobody new the ECB was insane until that rate hike, and then all hell broke loose.

[K]

Frances: "for a foreign bond holder, inflation risk = exchange rate risk."

I don't agree. I would say that (ignoring changes to the natural rate) to the foreign bond holder it's all just inflation risk. That risk is split between fx risk and rate risk. But as I said, *if* the policy rate follows inflation expectations then the real yield will remain constant and there wont be any fx volatility, since the exchange rate equilibrates real yields. The risk to foreign bond holders will then be realized entirely as nominal rate risk. The monetary authority decides how inflation gets split between interest rates and fx, but inflation risk is not fx risk.

As to "what were they thinking?" Bubble times are happy times, don't burst my bubble, mixed in with a bit of, look how wrong the Euro naysayers were, and how right we were! Nyah, nyah!

Left Outside: "Nobody new the ECB was insane until that rate hike"

It's true. Feared it, imagined it, definitely didn't actually believe it (still not 100% convinced). Along with the Trichet speech where he bragged how the ECB was even better than the Bundesbank because inflation was even lower, that was one of the definitive WTF moments.

[Phil Koop]

"the pre-Euro yield differences were almost entirely based on inflation and exchange rate risk"

Do you think that graph demonstrates this in itself, Frances? That is one possible story.

But there is an alternative story: perhaps perceptions of default risk themselves changed. Noting that there was no mechanism for country default, people may have concluded that the European polity would do what was necessary to maintain the Euro, which precluded piecewise default. I don't see how you can discriminate between these stories without drawing on some other evidence. In both versions, the observed convergence in yields before rates were fixed can be explained by some combination of increasing confidence that the Euro would happen (and expiry of risk as the date approached in the case of story 1.)

"Bubble times are happy times, don't burst my bubble, mixed in with a bit of, look how wrong the Euro naysayers were, and how right we were!"

That explanation is consistent with the second story but not the first. The first story is that country default risk was equal all along but the fact was concealed by inflation and exchange rate risk.

[Peter N]

You Can't say nobody predicted the euro as originally designed would fail. I'm not sure any predicted how bad the result would be. In retrospect it was inevitable. I takes a real and legitimate government to make painful decisions. Europe doesn't have one.

Nobody in a position of influence wants to be the skunk at a picnic. Whether the reason is ideological or political, the result is the same (always, alas).

[Frances Woolley]

Phil - interesting.

Your story presumes that bond traders were actually thinking about political processes, looking at the details on the treaties etc around the Euro and noting that there was no mechanism for country default.

I'm not sure that your story is more plausible than this one: Bond traders had, for years, evaluated bonds on the basis inflation or exchange rate risks. Since default risk was so highly correlated with inflation and exchange rate risk, there was no need to estimate default risk independently of inflation and exchange rate risk, so people didn't. It's only when things started to come apart in Europe that people started to realize that they needed to factor in an independent estimate of default risk.

K - I think we're basically in agreement, it's just that we're using different words to describe the same phenomenon. I'm more interested in the psychology of the bond traders, the *why* question. "Don't burst my bubble" is consistent with the kind of Great Moderation/End of History everything-is-different-now conversations people were having in the US and elsewhere at the time. What's the explanation for hubris?

[K]

Frances,

"Since default risk was so highly correlated with inflation and exchange rate risk, there was no need to estimate default risk independently of inflation and exchange rate risk, so people didn't."

That is exactly correct. As to why traders are prone to bubbles, I think it's a combination of 1) humans being prone to group think (people don't like to be the skunk) and 2) incentive structures (the skunk gets shot). Traders in large financial institutions know, for example, that there is no point making money when everyone else in the institution is losing, because the bonus pool gets decimated. So while getting long will land you a big bonus if the market bubbles on, you may never get paid if you're short.

And, for what it's worth, I still don't think we agreed on the bond risk :-) While fx is definitely a risk for bond investors, the fx risk has zero impact on the yields in that graph. In fact, the fx risk is absorbing some of the risk that you therefore *don't* see in that graph. Or look at USD/YEN. Plenty of fx risk between those two currencies yet yields are tiny. They could both have yields at exactly zero, yet there'd still be plenty of fx risk. Yields indicate nothing about fx risk. They *do* indicate inflation risk. I'll drop it now. I swear!

[Phil Koop]

Frances, this graph has been making the rounds and story 1 interested me because it is the first time I've heard it; most people have been quoting story 2. As it happens, there is a precedent for the market underestimating the relative risk of outright default versus inflation: the ruble-denominated GKO default in 1998. The conventional wisdom was that foreign-denominated bonds could default but a government could always print its own currency. The Russians confounded this by defaulting on some of their ruble-denominated debt but honouring some USD-denominated debt - they felt that the economic consequences of monetizing the GKOs would have been worse than the consequences of default.

You have now brought up a new story, story 3. In this version, market participants prior to the Euro thought in terms of undifferentiated risk from all causes, and when the risk from one particular cause declined they assumed that all risks declined likewise. I have to say that not many bond traders I know think this way. If they are thinking in fundamental rather than technical or psychological terms there is always endless decomposition and analysis - "actually thinking about political processes, looking at the details on the treaties etc."

[K]

...arbitraging the ecb's sovereign debt collateral rules, buying unlimited quantities of bonds that default only under the circumstances where you, yourself are already bankrupt or getting bailed out anyways, stuffing sovereign bonds into CDOs as undisclosed collateral for investments that are marketed for their derivatives exposures, ...

Oh yeah, and investment based on fundamental analysis of course (snicker)

[Bob Smith]

Does anyone have a similar chart for provincial/state bond yields over the same period? My instinct is that there would be material differences in bond yields between, say, PEI, New Brunswick, or Quebec, on the one hand, and say, Alberta or BC on the other, notwithstanding that we all share a common currency (ditto between, say, Texas or Alaska vs. California or Michigan). What's remarkable is that we didn't see those differences in the EU, notwithstanding that the US and Canada are currency unions which functional federal fiscal transfer regimes (and, at least in CAnada, a real history of the feds bailing out provinces).

Very odd.

[Frances Woolley]

Bob, I don't know of one, and this paper: http://www.rotman.utoronto.ca/~booth/Provincial%20debt.pdf which looks at provincial bonds seems to have been based on a data set the authors created.

[Bob Smith]

Frances - good find. Actually, those spreads between provinces are less than I would have expected, although they still (based on a purely eyeball assessment) seem to be larger that what we saw in the EU. What was so magic about the Euro?

[K]

Bob,

By '06/'07 the average investment grade credit was within of 30 bps of the swap rate. Canadian provinces (provies) which trade as very high investment grade bonds would have been within 10-15 bps of each other in the 10 year, similar to what you see in that graph. Canadian treasury bonds were 40 bps tighter than the swap rate, because of their special role in the payment system, but the spread differences between the provies would have been tighter than what we saw at the time between European sovereigns.

[Phil Koop]

Actually, I agree with what K said @2:34pm, at least in his (her?) first two points. What I meant to imply by "if they are thinking in fundamental terms" is that this is seldom the case. And in any case, trading is not investment. But for both types, it's mostly just a matter of seeing an angle in the moment and taking it. It's learning by reinforcement: peck - food pellet, peck - jolt.

[Peter N]

Previewing your Comment

The thing that made the mess so toxic was that

"Under EU rules a lender's exposure to government bonds in its domestic currency, such as the euro used in 16 member states, has a zero risk weight for determining capital buffers in case of default"

After the adoption of the euro, all euro zone sovereign bonds were denominated in euros and thus in the sovereign's domestic currency by definition.

I don't know whether there were any objectors who wanted to change the rule. It's clearly ridiculous without a guarantee from the ECB, and it may have been felt there was a Fannie Mae style implicit guarantee.

Surely some consideration might have been given to default, seeing as the eurozone countries have collectively defaulted 35-40 times since 1800.

The banks and sovereigns are now joined at the hip, and any cure must encompass banks and their countries. Anybody got a spare 2 or 3 trillion euros?

[reason]

What is interesting is that at the start of the Euro, investors were skeptical of Greece, but after 2002 they lost that skepticism are were only suspicious of Italy. (Italy's insistance on electing a corrupt buffoon must have something to do with that).

[Steve Roth]

"The convergence of bond yields after the Euro was introduced"

It sure looks like all the convergence (Greece excepted) happend before the Euro was introduced. It could have been in anticipation of that introduction, of course. But still, that requires somewhat different thinking and explanation, doesn't it?

[Frances Woolley]

Steve - "It sure looks like all the convergence (Greece excepted) happend before the Euro was introduced"

Before the Euro was introduced, all of the countries were trying to get their financial houses in order to comply with the Maastricht treaty - that could explain some of the pre-Euro convergence. Also - and here I'm really straying far from my area of expertise - the late 1990s were a time when people were starting to feel that the inflation of the 1980s really had been brought under control, and people's long-term inflationary expectations were coming down (remember these are 10 year bond yields).

[Simon van Norden]

Bond traders worry about exchange rate and default risk. The Maastrict treaty took care of both. Remember that the treaty limited govt. budget deficits to a maximum of 3% of GDP and govt. debt to a maximum of 60%. Countries violating those limits could be subjected to fines calculated as a fraction of GDP, which economists (and bond traders) thought would be sufficient incentive to keep governments on track.

What happened? The mechanism was tested when both France and Germany (!) ran afoul of the limits. The EU bureaucracy duly tried to impose fines, ignoring intense political pressure from national governments. The case wound up in court, which ruled that the bureaucracy did not have the constitutional authority to overule the EU council of Ministers. That effectively destroyed the mechanism to impose fiscal discipline. At the time, the ECB released a heated statement warning that this would have severe consequences down the road.

...and the rest is history.

[rsj]

At the time, the ECB released a heated statement warning that this would have severe consequences down the road.

...and the rest is history.

It is way too early to rewrite history so thoroughly.

The european nations cut their debt ratios in the run up to unification, but their banking sectors took on huge positions with too little capital.

The banks began to fail and the governments, at the insistence of the ECB, bailed out/guaranteed bank assets, causing their Debt/GDP ratio to balloon, at which point the ECB demanded structural reform not of its banks, but of the governments that are having a hard time cleaning up this mess.

Today, a Spanish Bank can borrow from the ECB at 1%, and use the proceeds to lend to the Spanish government at much higher rates. But the ECB will not lend to the Spanish government at 1% -- it demands that the Spanish government, whose balance sheet is in trouble because of the banks, cut wages and benefits to the non-financial sector, as well as cut pension benefits and salaries of government workers, so that the transfer of real resources to the financial sector can be increased. But the ECB is not demanding wage cuts and pension cuts of bank officials. Banks can continue to borrow as much as they want at 1%.

The rest is history.

[Simon van Norden]

rsj:
I'm with Krugman on this one; the main cause of unsustainable public debts in most eurozone countries (e.g. Greece, Belgium, Spain, perhaps Italy) is austerity/recession rather than the cost of bailing out the banks (Ireland is the obvious exception to this rule.) But if you think otherwise, where are you getting your estimates of the costs (to date) of bank bailouts in Italy? Portugal? Greece? Spain? What fraction of total govt. debt is that? of the increase in that debt over the past 5 years?

But I was mostly trying to respond to Chris Ragan's question: "What were they thinking?" (or "Why were they thinking it?") Because it looked like there was a rule in place, with an enforcement mechanism, that would curtail irresponsible fiscal behaviour. Then, they changed the rules.

[Bob Smith]

"Because it looked like there was a rule in place, with an enforcement mechanism, that would curtail irresponsible fiscal behaviour. Then, they changed the rules"

"Looked". But scratch the surface and everyone knew that the enforcement mechanisms were toothless (when France and Germany were running afoul of the rules what was the EU going to do, fine everyone?), that everyone and their dog was cooking their books in order to "look" like they complied with the Maastricht treaty, and that the Masstrich criteria didn't address the, not insignificant, off-balance sheet liabilities of the various eurozone countries (notably, pensions, future health care costs). This wasn't exactly a state secret, don't bond traders read the Economist (Wall Street Journal, Financial Times, pick your favourite business publication)?

[K]

Simon: "the main cause of unsustainable public debts in most eurozone countries... is austerity/recession rather than the cost of bailing out the banks"

I don't think it's so simple. The debts are unsustainable because the yields are huge. The yields are huge, in large part, because of the expectation that they will bail out the banks. If Spain would credibly announce "No bailouts. Ever!" there would be a monster rally in Spanish debt.

I think bailouts are a critical link in the story of how adjustment resulting from past current account imbalances are forced to be borne entirely on the backs of the periphery. Defaults, on the other hand, would be a way to share the pain with wealthy foreigners (who richly deserve it anyways).

[rsj]

But if you think otherwise, where are you getting your estimates of the costs (to date) of bank bailouts in Italy? Portugal? Greece? Spain? What fraction of total govt. debt is that? of the increase in that debt over the past 5 years?

The banking system is an off-balance sheet liability of the government. Therefore when the private sector -- and this was a private sector debt bubble -- engages in unsustainable lending, at some point there will be a banking crisis and the government steps in to rescue its domestic banking system.

It is the recognition of this liability that causes investors to question the solvency of the government (assuming the government is not monetarily sovereign, of course). This creates a feedback loop in which rising debt service costs create additional doubts about government solvency which create rising debt service costs. Of course the above only holds for governments that do not control their debt service costs -- the UK, Japan, US, Sweden are doing just fine with low yields. Not because they have better banks or sounder finances, but because they set their own borrowing costs, whereas EMU nations cannot. The EMU nations are vulnerable to market sentiment, whereas bond market sentiment in sovereign nations consists of trying to determine at which level the government will set rates next month.

In some sense, it is no different than what happened to the U.S. banks, who had enormous off-balance sheet liabilities that were deteriorating. The discovery of this created an environment in which rising funding costs threatened the solvency of the banks. In that case, the U.S. government stepped in and lowered those funding costs and injected capital. It was a run on the banking system. Again, the key is the ability to directly lower funding costs, not to assuage whatever market sentiment is out there.

You can have a run on any entity that cannot control its debt service costs. What the EMU is doing, if we are to be generous, is trying to prevent any sunspots from occurring, because it blames the run on the sunspot. For this reason, Germany, too is vulnerable. It has an enormous banking system filled with toxic assets.

Hence all the talk of "confidence".

Rather, the blame should be assigned to a system so vulnerable to sunspots -- the ECB is the one fundamentally responsible for this crisis, and the immediate trigger was reckless private sector lending.

Instead of focusing its efforts on restructuring (and eliminating) itself, the ECB is demanding that pensions be cut in those nations that are vulnerable.

Those nations that are monetarily sovereign are not in such a precarious position, even though they have large budget deficits and equally precarious banking systems, and so they are free to pay pensions. The only difference is that they have adopted a more stable regime and so don't need to be afraid of every sunspot. Moreover, the ECB only sees sunspots selectively. It had no problem with the massive increase of private debt, and did nothing to demand bank reform.

[rsj]

And I should add that the die was cast with Ireland. During those frantic days when there were large outflows from Irish banks, the ECB covered those outflows but only if Ireland agreed to guarantee the entire banking system. And immediately Ireland was turned from a neo-liberable poster child into a basket case of reckless public spending.

At roughly the same time, Iceland, which was not in the claws of the ECB, refused to take on its banks' debts, and it was allowed to continue to run counter-cyclical budget deficits and focus on the stabilizing the real economy.

[rsj]

There is a nice article by Soros about this here: http://www.project-syndicate.org/commentary/the-accidental-empire

[Simon van Norden]

rsj: facts, please.

[Simon van Norden]

K:
"The debts are unsustainable because the yields are huge." We agree.
"The yields are huge, in large part, because of the expectation that they will bail out the banks." Really? Not because people are rioting in the streets and unemployment is 20%? Let me just ask, how could we reasonably expect to distinguish these two cases?

[Patrick]

rsj, Simon: why can't it be both? IMO, neither of your propositions precludes the others.

[K]

Simon,

"how could we reasonably expect to distinguish these two cases?

I said the expectation of bailouts are a *large part* of the story, not the only part. Don't forget, Spanish debt to GDP is not very high. If you are a bond investor looking at Spain how would it not matter if debt to GDP could increase enormously. It would take a decade of depression to run up that kind of extra debt via austerity generated deficits alone. Imagine the positive impact on spreads if you left that extra debt burden where it belongs, with foreign creditors.

[K]

Simon,

Which is to say, I don't think these are things which, as Patrick says, we need to distinguish between. Whatever causes the expected path of debt/GDP to grow (depression, bank bailouts) will cause spreads to widen, which in turn will cause more depression. What's important though, is that depression is not something the Spaniards have direct control over, *except* to the extent that they can choose whether to bail out the banks and thereby hugely aggravating their debt problem, or not.

At least in the Irish and Icelandic cases the IMF, who opposed bailouts of banks, was a countervailing balance to the ECB. I get the impression that that has changed significantly under Lagarde, which may be part of the reason that there does not appear to be a glimmer of hope that Spain will follow the Icelandic model. Then, since unlimited bail outs now appear inevitable it doesn't matter much to Spanish debt holders whether they occurred in the past or the future.

[Bob Smith]

K: "I don't think it's so simple. The debts are unsustainable because the yields are huge. The yields are huge, in large part, because of the expectation that they will bail out the banks. If Spain would credibly announce "No bailouts. Ever!" there would be a monster rally in Spanish debt."

Really, if the market believes that the Spanish banking sector would collapse, they'd have greater faith in the Spanish governemnts ability to repay its debts? I'm not a banking expert, but generally the prospect of widespread collapse of the national banking system isn't taken as a sign of economic vitality. I would have thought that the market would be every bit as likely to take that as a sign of the general collapse of the Spanish economy. In some sense, the Spaniards are faced with a catch 22, do they end up with a pubic debt problem, requiring years of austerity, or a banking sector problem, which is likely to leads to years of slow/no growth.

Patrick's right, its both.

RSJ: "At roughly the same time, Iceland, which was not in the claws of the ECB, refused to take on its banks' debts, and it was allowed to continue to run counter-cyclical budget deficits and focus on the stabilizing the real economy."

I"m not sure Iceland is a particularly compelling counter-example, since it's economy has also shrunk significantly in the face of its banking crisis, unemployment has skyrocketed, real wages have fallen, and its debt-to-gdp ration has quadrupled. In other words, it has the exact same problems as the Spain, Italy, etc. despite being outside the euro zone.

[Simon van Norden]

Bob Smith: "everyone knew that the enforcement mechanisms were toothless (when France and Germany were running afoul of the rules what was the EU going to do, fine everyone?)"

Yes. And the European Commission tried to do exactly that. And they took it to court to enforce it. And they had important support from several quarters (including the ECB) during that process. So you and I disagree about the irrationality of bond investors who took comfort from the Maastrict Treaty process.

"...that everyone and their dog was cooking their books ...."
Yet the figures had to maintain a connection to reality to be certified by the EC, which was thought to act as a meaningful constraint on fiscal policy.

[K]

Bob,

"Really, if the market believes that the Spanish banking sector would collapse, they'd have greater faith in the Spanish governemnts ability to repay its debts?"

There is *nothing* that prevents the national deposit insurer from running failed banks. If you unburden the banks of their non-deposit debt, it becomes much easier to continue lending operations and thereby sustain the economy. It's been done many times before. Sweden, whose banks were nationalized and soon after re-privatized, showed the way in the early '90s. The IMF was strongly advocating the same course for Ireland, but they chose to buckle under to the ECB. The point is to cut the debt, public and private. Only bankruptcy can do that quickly and painlessly (except, of course, for the creditors).

[genauer]

I remember when in fall 2008 people in Germany looked in utter disbelief, when the Irish government gave blank guarantees to all banks in Ireland. In hindsight, some of them were operated by non Irish majority owners, why not let them fail ?

In Spain, it is spanish cajas, making spanish mortgages, controlled by spanish supervision, and there is ZERO reason, why now suddenly alien tax payers should have anything to do with them.

Last thing I heard they sold junior debt to spanish savers as "safe". 100 % reason for Germany to keep the Spanish government 100 % responsible for that.

[Determinant]

The actions of the Irish government, at the time, were at the behest of the ECB and therefore Germany, given the debt interconnections.

Second, Germany apparently has a rogue ambassador in Canada as said ambassador is criticizing the Government of Canada for not contributing to the IMF to pay for European bailouts. The ambassador uses the same logic you have dismissed as "anti-ordnungpolitik", genauer. I fear the distinguished ambassador has lost the script.

http://www.theglobeandmail.com/news/politics/harpers-refusal-to-help-bail-out-europe-draws-germanys-ire/article4240996/

[genauer]

Determinant,
your globeandmail reference:

“We find it indeed somewhat irritating"

Germany’s ambassador, Dr. Witschel, said the Prime Minister’s comment that any growth agenda should not be financed by more debt was “most welcome.”

Do you call that "Germany's ire" ? Shall I remind you what a "furor teutonicus" looks like? And how does this justify to call Dr. Witschel "rogue" ?

I see Mr. Harper pretty much in line with German Ordnungspolitik:
"But Mr. Harper isn’t budging as he carves out an agenda directly opposite to those of the high-debt governments of Europe. He chose Davos earlier this year to announce a long-term economic plan that includes raising the eligibility age for Old Age Security, partly to contrast Canada with the generous but unaffordable entitlement programs that are partly to blame for the trouble in Europe."

Germany did that already in 2003.

Conservative MP Pierre Poilievre put it another way in the House of Commons.
“This Prime Minister will not force hard-working Canadian taxpayers to bail out sumptuous euro welfare-state countries and the wealthy bankers that lend to them,”

This holds for hard-working German taxpayers exactly the same.

no-bail out, no money printing is the law

[dwb]

"Since default risk was so highly correlated with inflation and exchange rate risk, there was no need to estimate default risk independently of inflation and exchange rate risk, so people didn't."

sargeant and wallance have some early 80s papers on this. for a sov that prints its own currency, there is no difference between "default" and inflation. inflation is a form of default.

K commented that they started to diverge after the rate hike in 2011. At any point this divergence would be reversible through monetary policy. Lars Christensen has a nice graph (see below). Forget about the single rate hike, the entire policy (including the last one, where they held steady) has been a fiasco.

the ECB actually used to have two pillars, one of which was M3 growth of 4.5%... imagine if they had kept that, we would not be here today.

I interpret the yield differential as (effectively) the implied inflation rate needed to create convergence again... if the ECB ever starts printing money. which at this point requires Merkel to sign up for fiscal union. soon.

http://marketmonetarist.com/2012/05/14/failed-monetary-policy-the-one-graph-version/

http://marketmonetarist.com/2012/05/30/jens-weidmann-do-you-remember-the-second-pillar/

[genauer]

dwb,

rates / CDS risk premia started deviating since Lehman. When people started to look at the risk of what they bought. M3 targeting is something that was abandoned for inflation targeting around 1980, never heard of this "2nd pillar" theory so far. Do you have some reference or is that your creative contribution as of now ?

Spain has tried to hide their bank problems, acknowledged that the last socialist administration also had fudged the books, and has now agreed to apply for ESM money to fix it, and this does include IMF / Troika adult supervision. Italy looks like following in a few weeks. What is, how shall I say it, worth to mention, that both have not signed the ESM treaty yet. If things crash on Monday, they are not eligable for this help, by their own choice.
I dont think that would justify any other help.

ECB politics has nothing to do with their overspending problems.
I thank Determinant for bringing the relevant globeandmail reference with the view of Canadian politicians for that.

[dwb]

@genauer,
its hard to say the exact moment they deviated.

yes, do a google search or look it up on the Bundesbank website for the "second pillar" monetary analysis which was about 4.5% M3 growth. Draghi even mentions "the monetary analysis" every press conference.

here is a paper from 2000:

"“The ECB announced a reference value for M3 growth of 4.5% calculated as the sum of an inflation target and a foretasted trend growth rate of real output of 2.5%"

http://www.cesifo-group.de/portal/pls/portal/docs/1/1191022.PDF

[genauer]

dwb,

I looked at the IFO paper, and wonder, what that should tell me.
It talks about what to do about a short term business cycle shock, like we had in 2008.

But we are dealing here with deep long term structural problem in the GIPSI with debt fueled overconsumption. And the very transparent attempts to blackmail the german taxpayers into gigantic wealth transfers.

Where do I see some Current Account, Unemployment.

It is late in the night for me, but I am at a total loss, what this paper should tell me about any specific action to take now.

Please be specific with the relation.

[dwb]

@Genauer,
Sorry: the only point i was making was that the ECB early on (1999) adopted the second monetary pillar for 4.5% M3 growth, which is referenced in the paper. That's it.

[Determinant]

genauer:

Perhaps the original article wasn't clear enough. The German ambassador asked Canada to contribute to the IMF to bail out the PIIGS, and Canada has consistently refused. The hypocrisy is that Germany has refused to take the same steps.

From the German ambassador:

"We find it indeed somewhat irritating and somewhat disappointing that Canada is so adamantly refusing to help," he said. "A major problem in the euro zone would have major negative economic repercussions on Canada, so solidarity is needed. … We still hope that Canada would be ready to contribute more, like so many other partners."

Hmm. He appears to have dropped the script and gotten lost. Would someone please come an collect him?

Shall I remind you what a "furor teutonicus" looks like?

If that was supposed to be funny, it wasn't. If that was supposed to be hyperbole, it was both in poor taste and poor rhetoric. It also sails dangerously close to Godwin's Law.

And, erm, IIRC such "furor" has historically resulted in Germany being required to sign surrender documents.

[dwb]

btw, my answer to "That's what they were thinking. But as Chris says, the question is: Why? "

is:

the assumption when the Euro was created was (in my mind) that it was but stage 1 towards fiscal and political union. (stage 2). Now I think there is an equivalence between "fiscal transfers" and a common EU tax (for example) and EU-wide inflation (which itself is really a tax). Common EU inflation is just another way of socializing "default losses" or implementing a common tax.

When it came time to cross the bridge to a true fiscal or monetary union, leaders blinked. "wait, we dont want to give up sovereignty, we dont want to pay for French pensions. "

there are true cultural and linguistic barriers, and to be fair, Germans do not get a vote on French pension schemes.

in another sense, the political leaders incentives are not aligned with the common interest. Merkel wants to postpone any decision until it is politically safe, because whichever path she picks (Euro break, or a fiscal union) has negative political repercussions.

I think the market started to diverge when the ECB failed to act, and political leaders failed to act, making moving to a fiscal and political union became questionable. and it was never really in political leaders interest to push a political union in the first place, until now.

[The Keystone Garter]

...there was also a demand for EU instruments as it became an alternate to USD, and China's middle class also came on board. If European banks can borrow at %1 and can't find anyone to lend to, this suggests to me extreme diminishing ROI of this post WWII economy. Why is it treason to suggest waiting to see which of the USA's wind turbine scalaeable materials, R+D, is successful in 2013 and build copycats of those designs? And build metal solution-phase batteries; seen a giant antimony-salt-something else prototype. The ECB is designed to preserve price stabililty, whereas poorer nations need intelligent investment: stimulus. Greece needs a tax revenue ROI that returns more than deficits grows by, in addition to austerity. Basically, when employment is 10-15% below your neighbours, that is the obvious use of money. Banks haven't used their %1 borrowing to fix this. Vestas teamed up with eco-ARPA and a Chinese utility-scale battery manufacturer....make the future and tax them. Bankers are dumb and greedy.

[genauer]

@Dwb
That the ECB had a dual inflation and M3 target in the past as late as 2002, is an interesting curiousity, and good to know. It is also the first case I am in agreement with something from CEPR:
http://specials.ft.com/euro/FT3X4BK1M0D.html „ "It needs demolition, not cosmetic improvement," the report says.”
Today “the ECB has only one primary objective with other objectives subordinate to it” (ECB wiki) Price stability. And that is defined here: http://www.ecb.int/mopo/strategy/pricestab/html/index.en.html In neither link M3 is mentioned anymore.

@determinant
It is the job of the IMF to “provides resources to help members in balance of payments difficulties”. Please see their Overview Page. It is the individual countries, which are members of the IMF and not the ECB.
“It also lends to countries in difficulty, and provides technical assistance and training to help countries improve economic management”
It is especially the “technical assistance and training” part, which we value, especially given the nationally neurotic behavior of folks like Greece, when they get some adult supervision. Even now they blame everything on Germany. So it is indeed somewhat irritating that Canada and others refuse to do the job for European countries anymore, but I have some understanding for that.
The IMF has people who did the prior for other countries, has some experience how to deal with intransigent patients, without formal power, an experience the Bundesbank doesn’t have. We only know, how to take control over “Länder” and our Municipalties, based on clear laws, and this could be with armed forces, if necessary.

“furor teutonicus” actually goes back to roman times, but, well, another example that irony doesn’t travel well on the internet.

@rsj
Germany has activated SoFFin (2) again, http://www.n-tv.de/politik/Bundestag-winkt-Soffin-II-durch-article5329351.html providing up to 480 * 1.25 = 600 billion Dollar in capital to German banks, if needed. I think that is more than their whole capital. The bundesbank did another stress test of the German banks:
http://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_1/2012/2012_03_07_dkp_04.pdf?__blob=publicationFile
We are prepared for Armageddon.

The blanket guaranty of Irish bank debt was the idea of Irish PM Ahern alone, as we remember that watching in horror here in Germany.
The Spanish bank problem was and is a Spanish problem. After 2 Rounds of LTRO, I doubt that there is much Spanish stuff anymore in German hands. Spain created the problem, Spain is 100 % liable for the ESM credits they will get, and it comes with Troika strings attached.
That they fudged the numbers and tried to push it onto the EU taxpayers, means simply that Spain also can not be trusted anymore, and sits squarely in the bad boys corner.

My answer to “why” is, that from my perspective the costs of bankruptcy, personally and national, are high, but you don’t see it directly. People demand up front payment, charge somewhat higher prices, high quality industry / jobs unavailable. Etc. etc. Just look at the desperate capital flight from Argentine.

So you expect mature people / countries to avoid bankruptcy. Greece and many others got huge subsidies from the EU, they got access to a large free market, and we expected them to become like the Nordics and Germany. Well, that didn’t work that way.
As Acemoglu in “Why nations fail” explains, certain patterns of behavior, corruption and cronyism are extremely hard to change. So with Greece.
What we now also realize is, that a lot of people don’t care about treaties, law, other people’s property rights, in supposedly civilized nations as our European neighbors, and at home as well. Given how thin the forces of order are, it looks like a miracle, that things actually work as good as so far.

@dwb
What you describe as “ECB failed to act”, would be just criminal acts. The no bail out, no money printing is the treaty. And this is there for very good reasons. If somebody tries to break it, in a fundamental way, we will pull the plug. Period.

@Keystone
To attract some high tech industry, you need high quality tech people and a stable, investor friendly environment. Both is completely absent in Greece. Whatever little sprouts were there, they destroyed in the last few years, the active, intelligent young folks have left the country, and you cant blame them.
In February our vice chancellor came in with a herde of German industry folks. Photovoltaics should work there much better than here. Nothing happened, they don’t like foreign investment, just cash please and no questions asked.

[genauer]

One more thing:

First order, I could live personally with the high-inflation regime so many folks in the banking sector seem to like. I have very little bonds and bunds. The lower 20 % don’t have any assets, the upper 5% can arrange with whatever comes, leave the country. The folks who get damaged are the middle 75%

I take the recent Pew Survey
http://www.pewglobal.org/files/2012/05/Pew-Global-Attitudes-Project-European-Crisis-Report-FINAL-FOR-PRINT-May-29-2012.pdf
as a sign for that many people in the other European countries feel similar, the approval ratings of Germany and Merkel are very high, and mostly higher than their own leaders, see pages 40 and following.

We are pretty confident that Ordnungspolitik is the right way to go into the future, simple, stable, robust. Germany is still, and only as a few, positive about more integration, and if there would be some real common control over spending, certain common liability is not unthinkable. But there will be no blank cheques, and definitely not for folks who consider a higher standard of living than us as their birthright.

[rsj]

The blanket guaranty of Irish bank debt was the idea of Irish PM Ahern alone,

And that it happened when a delegation from the ECB was visiting Ireland on an emergency meeting was purely coincidental? You are the only one in the world who has this interpretation of the events. What happened was that the markets understood the bank debt was bad, and the Irish banks could not access short term liquidity funding. They began to TAP the ECB emergency lending facilities, and the ECB told Ireland to guarantee the debts or the funding would be cut off. Since that, it has become official ECB policy, and the ECB continues to pressure Ireland to expand the gurantees and renew them when they are due to expire, using the exact same threats, as Irish banks still cannot access liquidity funding. http://www.ecb.int/pub/pdf/other/recommendations_on_guaranteesen.pdf

http://www.thejournal.ie/colm-mccarthy-irish-bank-debt-was-incurred-under-threats-from-ecb-388798-Mar2012/
"Irish debt was incurred “under duress and inappropriately, under threats from the European Central Bank”."

http://www.usatoday.com/money/world/2011-04-01-irelandbanking.htm
Ireland wants bank creditors to bear pain, ECB says no

"Noonan said Ireland would not act unilaterally against the orders of the ECB, which along with the European Commission has been against forcing losses on bondholders since Ireland’s banking crisis erupted in 2008. European financial chiefs made protection of senior bondholders a condition of its November bailout agreement with Ireland’s previous government, which was ousted from office three weeks ago amid voter fury over the terms of the deal."

"Noonan said a minority of governors at the Frankfurt-based ECB, notably Germany’s Axel Weber, agree with the Irish and American position, and he still hoped it would prevail in the medium term. But he said Ireland had to give up its hopes of greater burden-sharing for now because the ECB is the key source of short-term funds for all of Ireland’s banks, none of which is able to borrow on open markets.
[...] ECB policy means Ireland cannot impose cuts on 16.4 billion euros in senior bonds that are unsecured and outside the scope of Ireland’s bank insurance. Nor can the Irish prune any of the 19 billion euros in secured but unguaranteed bank bonds."

http://www.independent.ie/business/european/ecb-seeks-new-guarantee-on-interim-bailout-2598091.html

ECB seeks new guarantee on interim bailout

"The Government has also been battling to ensure that the latest banking bailout finally ends the links between the fate of Ireland's banks and the fate of the Irish sovereign.
It is understood, however, that the ECB wants the Irish Government to guarantee some of the sums advanced to Irish banks by the new medium-term facility, an arrangement that would see the fate of the sovereign and the banks remain entwined.
The issue arises because the €70bn of so-called "exceptional liquidity assistance" being provided to the Irish banks is covered by an explicit government guarantee. The ECB believes this guarantee should migrate over to the new facility."

And your belief that inflation "hurts the middle class" is extremely odd. The whole moralizing thing is creepy.

[genauer]

@rsj,

where is your evidence that this was done on the request or whatever of the ECB.
Please provide date, participants, names and evidence / links for that.
I do not see anything like that in your ECB link above.

The Colm link also does not provide any evidence beyonnd some very wild vague claim.

[rsj]

Well, genauer, the exact communications are not open to the public. But the participants in the meetings said the ECB demanded guarantees, the credit markets believe this, and basically everyone except for you. The ECB certainly acts like it, demanding additional guarantees. That is enough evidence for me.

Here is the IMF disagreeing with the ECB about forcing Ireland to guarantee bank debt:

http://www.irishtimes.com/newspaper/finance/2012/0616/1224318055997.html

"The IMF called for “stability” in the European Central Bank’s funding of the Irish banks. This echoes repeated requests by the Government and its predecessor for a medium-term ECB funding arrangement for the banks. The ECB has consistently rejected making exceptions to its liquidity provision mechanisms for Irish banks.

The report distances the IMF from the decision to repay senior creditors in defunct banks and explicitly attributes the decision to the ECB, which insisted on the repayment because of its concerns about “pan-European financial stability”. It implicitly criticises that decision, saying that the “lack of burden-sharing on senior bank debt as part of the resolution process added to government debt, exacerbating the political difficulties with the annual payments of €3.1 billion due on the notes until 2023”.

Since you seem to view everything through a lense of nationalism and collective guilt or virtue, I thought you would be happy to hear that a minority of German representatives within the ECB sided with Ireland.

[Michael]

Didn't Basel II capital rules provide 0 haircut on all European sovereign debt? If so, isn't any spread inevitably arbitraged to 0? Wasn't that the point?

[genauer]

@ rsj,
again, when was the guarantee given by whom, and when did the ECB or any other non-irish get involved.

[rsj]

The first guarantee was given by the Irish Government because the ECB said that they would not provide emergency loans to Irish Banks (liquidity support) unless the Irish government guarantee was provided.

Since then, there have been additional guarantees under the same circumstances, to extend protection to senior Irish bank creditors that were not protected by the initial guarantee. You can read about the details from the links I provided, or do your own research.

[genauer]

rsj, when is the question !

[genauer]

@rsj

I strongly reject your allegations “to view everything through a lense of nationalism and collective guilt or virtue”. I just reject that the German taxpayers have to pay for other nations bad decisions.

Second, it was a Taoiseach Brian Cowen on 1st of October 2008, who made this gargantum guarantee
http://www.guardian.co.uk/business/2008/oct/01/banking.creditcrunch1

and for some spicy commentary
http://www.vanityfair.com/business/features/2011/03/michael-lewis-ireland-201103

Your source above says “European financial chiefs made protection of senior bondholders a condition of its November bailout agreement”
[28th of ] November [2010] when the hyperbole came to an end and Ireland had to go to the IMF, and not 1st of October 2008, a little difference of just 2 years.

He was as the finance minister 2004 – 2008 in charge of the whole mess.
His wiki says “Cowen's third budget in 2007, in anticipation of the 2007 general election, was regarded as one of the biggest spending sprees in the history of the state”

I have asked you, rsj, 3 times nicely to provide evidence for your now apparently false claim, that this was not a unilateral Irish decision on 1st Oct 2008, to pledge some 200% of the Irish GDP.

And, quite frankly, you are typical of these many claims now, how other countries fiercely defending their own independent decision making , then later turn around, and claim they were pushed way earlier, by the usual suspects, the EU, the ECB, the bad Germans, somehow. And each time you go for details , time sequence, the claims never hold water.

First Ireland made its pledge, got people to extend credits to the banks based on that, because they were now backed by the whole nation, then 2 years later Ireland found, they need help, get a very generous package, which includes that liability, and then starts a never ending nagging, to default somehow on this part of the parcel, without taking the consequence the Irish state defaulting on its commitments, a national default, without being called that.

All the while with plenty of own meat to cut, exceptionally low taxes, high public salaries.
Somehow, in the end, always the German taxpayer should pay other peoples debt.
The credit rating of Ireland reflects this kind of behavior, in CDS premiums and interest rate spreads as well.

[rsj]

Look here: http://www.finance.gov.ie/viewdoc.asp?docid=6474

Basically, a limited scheme was put in place for 1 year, and was repeatedly extended each year after that. Moreover, additional forms of creditors were included as a result of ECB pressure -- e.g. short term debt, subordinate debt, etc. Each time, as the scheme is due to expire, the Irish gov. is trying to untangle itself from the bank debt, and the ECB steps in and says "no", threatening to withhold short term funding for the Irish banks unless the government caves in and extends the guarantees by another year. ELG alone has been extended 4 times now, 2008, 2008, 2010, and 2011, 2012. I am sure that as Dec 31, 2012 rolls around, another extension will be announced, even though Irish parties lost office and the guarantees are wildly unpopular in Ireland.

The only credible way that Ireland can stop the guarantees is to leave the euro, as each nation requires a functioning payments system, and if the ECB withholds those funds, then the entire payments system collapses. So in order to force these unpopular guarantees, all the ECB needs to do is threaten to withhold liquidity if ever the Irish propose to impose haircuts on bank creditors -- something that IMF has criticized them for in the passage I cited.

Now, do your own research. I've more than made my case here.

[rsj]

Genauer, I provided lots of data. But everything has to be some black/white moralizing fairy tale of national imprudence with you. And you are completely wrong on all counts -- everything from your bizarre view of inflation just around the corner devasting the middle class to some supposed imprudence on the part of ethnicities that you don't like. I am truly sorry. Go and defend the honor of the "German taxpayer" if you like. Turn everything into a false morality play and blindly ignore the facts.

What that has to do with the ECB forcing the Irish taxpayer to bailout for-profit private sector banks is beyond me.

[rsj]

Oh, here is a nice ABC news story about it:

http://www.abc.net.au/4corners/stories/2012/03/08/3448633.htm

"Basically this is extortion and that's what it is. It's extortion. It's the bullyboys of Europe, you know, the European Central Bank, the financial bullyboys of Europe forcing us to pay a debt that was never ours..."

Of course, we know what *really* happened. It was the imprudent irish who are irresponsible and threatening to sink the euro, the strength of which is a sign of German national virility.

[Determinant]

genauer, speaking ill of the Irish will get you little sympathy in Canada and on this blog, anybody whose family has been here for four generations or more has an Irish ancestor.

The fact is that 1998-2008 Ireland became a net importer of people rather than a net exporter, which it had been for 200 years previously. Millions of Canadians' families washed up on these shores due to previous hard times in Ireland, mine included.

Leaving the Euro is exactly what Ireland should do. Greece too. The whole thing won't work and prosperity is not around the corner while it is in use.

[genauer]

@Determinant,
If you think I „spoke ill of the Irish“ and it is not just a fact, then please be specific, where that was.
Otherwise I agree with you, that people who can not or want not live by the Maastricht treaty rules, should leave it (the Euro). I doubt somewhat, whether that really makes them better off, but at least it would be my concern any longer.
@rsj
You “provided lots of data”. Well, yes, just not the relevant.
Your Irish Department of Finance overview page provides lots of links to some official mumbo jumbo:
The unilateral Irish government gargantum 200 % GDP pledge on 1st of October 2008,, as in the guardian link above, shows up as “which provides that the Minister may provide financial support in respect of covered liabilities of any credit institution or subsidiary which the Minister may specify by order”, in
http://www.finance.gov.ie/documents/publications/statutoryinstruments/2008/si4252008.pdf

Which normal person would read this as what was said publicly?

Do you have any specific link there to disprove me on some specific item?

How does this show that any non-Irish was involved in this?

So I am at a total loss, where you believe to have contradicted me in any single case.

Furtheron, you say “ELG alone has been extended 4 times now, 2008, 2008, 2010, and 2011, 2012”, whereas http://www.ntma.ie/ELGScheme/CreditInstitutionsELGScheme.php states:
“The [..] ELG Scheme [..] came into effect on 9 December 2009 and was amended on 29 September 2010”, so again you have a 2 year gap between your claims and the information provided by official sources.

So I am at a total loss, where you believe to have contradicted me in any single case.

You come with some general journalists rant (your ABC link) citing some anonymous,
Ill give you the exact date statements of the official institution NTMA.

Your “But everything has to be some black/white moralizing fairy tale of national imprudence with you.” Please be specific, where you believe this has been the case.

I am not defending nor attacking any’s honor, I just defend my wallet, vigorously : - )
As in the night walking through Harlem or Cuba, I am not afraid.

[dwb]

@genauer,

price stability is not legally or economically well defined. Just because the ECB picked HICP, does not make it appropriate, legal, or sound policy. That's why the M3 is an important indicator: import prices or banking/velocity shocks can create the false impression of price stability in the face of downwardly rigid wages. The ECB made up a definition for price stability and therefore they can change it.

[dwb]

@genauer,

and by the way, the treaty does not say "no money printing." In fact, the ECB has printed a lot of money. The treaty only talks about price stability, whatever that means. I say: the ECB should only print enough money to maintain 4.5% nominal income growth, period, by any meas necessary. Thats my definition of price stability.

[RebelEconomist]

rsj, genauer

Sorry to turn up late for this debate! This claim that the Irish blanket guarantee of their banks' liabilities was made under ECB pressure often comes up, so I have looked into it before. On the basis of the public comments made at the time, I believe Genauer is correct to say that the initial Irish bank guarantee of 29th September 2008 ( http://www.finance.gov.ie/viewdoc.asp?DocID=5475 ) was made unilaterally. In fact, it came as an unwelcome surprise to other EU countries, which then felt under pressure to match the Irish move to head off a shift of their own banks' deposits to Irish banks: http://www.guardian.co.uk/politics/2008/oct/02/alistairdarling.ireland

[genauer]

Welcome RebelEconomist !
And when we look back at the Irish 10 year rates of 5% http://www.bloomberg.com/quote/GIGB10YR:IND/chart (please take the 5 year view!)
Or CDS ridiculously low (well, hindsight is 20/20) as 0.6% http://www.bloomberg.com/quote/CT777651:IND/chart
This came pretty much out of thin air for me at this time.

What were they thinking?
European countries, who did sign up for strict Buba Rules with the ECB defaulting? Unthinkable! Well, in the moment somebody spells out a 200 % GDP guarantee, you are in the first moment speechless, and then you realize, that the guy is either crazy, or doesn’t know what he is doing, or isn’t really serious about what he commits. Whatever it is, as an investor a very strong reason to get away as fast as possible.

When Germany reactivates the Armageddon protection SoFFIn for German banks, to the tune of 15% GDP (450 b / 3 000 b, roughly), this is a very credible statement. 200%, obviously not. As in Iceland.

@dwb,
We had this discussion across 3 blogs about Inflation and targeting, and why the HICP /ECB are alright. You put forward the argument, why Germany might already be vulnerable to blackmail, good links to the BIS, and I believe to gave you back a calculation, why this is not the case, yet.

I extended recently a little bit on the 2.0% target at http://uneasymoney.com/2012/06/11/how-did-we-get-into-a-2-percent-inflation-trap/#comment-6055
(with the link to the original discussions with “dwb”. For the other readers)

You might find that useful. Especially the point that even if NGDP would work in one nation, it does not work in a many nation currency union, because of the tremendous moral hazard.
We also talked about, how the LTROs could be used for some low-national-emotion / rule breaking transfers.

The problem I was not aware of, Spain (cajas) and probably Italy and Germany “local banks” sold a lot of junior debt to their “75% middle class”, whose definition “rsj” doesn’t like.
According to the rules, they would have to stiff them first, and if these people then draw the knife on government, then we can indeed get back to a 1930ties scenario.

But a nice try to get to NGDP targeting via that M3. I appreciate that, technically : - )

[RebelEconomist]

And, for the record if no one is reading this post now, the following blog post, and the Irish Times article it refers to, is also relevant to the debate about whether the ECB twisted Ireland's arm to guarantee bank debt: http://www.irisheconomy.ie/index.php/2012/06/08/mistakesself-interest-versus-european-pressure/