Thursday, July 26, 2012

The ECB weaponry

The current euro crisis was named by Nouriel Roubini and several bloggers as “a slow motion train wreck”. In the last twelve months the trains have continued their collision course and actually have accelerated their speed, but the crash is not a foregone conclusion. There are still courses of action - though admittedly problematic - that might avoid the collision.
Germans are opposing the so-called “mutualisation of European government debt”, through the issue of bonds for which each and all EMU member states would be responsible jointly and severally. Quite reasonably, we argued in our last post, for inevitably they and the few AAA-rated members would end up paying for all.
Germans are also opposing an increase in the funds of the European Stabilisation Mechanism, much less reasonably in view of German exposure to the euro crisis. Indeed, the operation of the ESM as an anti-spread shield, which seemed to have been agreed at the Economic Council of 28-29 June and would gain a bit of time to look for other solutions, is being delayed when it is most urgently needed, by the temporizing tactics adopted by the German Constitutional Court. 
Also, Germans are not even contemplating the sheer possibility of reflating the German economy, most unreasonably because this not only would cost them nothing but would benefit them first and then the whole eurozone by reducing the German trade surplus and facilitating overall re-balancing of the entire eurozone. Paul Krugman had suggested that Germany should pay all of its citizen a 1000 euro voucher to spend in Southern Europe - an excellent proposal which naturally fell on deaf ears.
The current euro crisis has reached a new depth, with bankrupt regions and metropolitan cities in Spain (Valencia, Mursia, Cataluna) and in Italy (Alessandria; allegedly Sicily; with another 10 cities feared to be at risk of default given high debt and bad investment in derivatives, see La Stampa, 23 July); record spreads; rating downgrading and negative outlooks leaving only Finland at a stable AAA grade; a tough line on Greece taken by the troika (EU, ECB, IMF); and the inexorable recession induced by excessively fast fiscal consolidation.
In these circumstances, the European Central Bank is the only institution left that has the means to intervene with any effectiveness. Granted, the ECB is not allowed to act as Lender of Last Resort to governments, because of the No Bail-Out clause in the Treaties. It can acquire government bonds of countries under speculative attacks on a limited scale under its Securities Markets Programme (SMP), that started on 10 May 2010, which however has already come under criticism. And in December and February the ECB has injected a total of €1 trillion of liquidity into the European banking system through its Long Term Refinancing Operations (LTRO, also re-labelled as Lourdes Treatment and Resuscitation Option, 28/04/2012). This could be repeated, but not indefinitely, and in any case it is a rather blunt instrument, for only a fraction of the injected liquidity finds its way to support government bonds.
Nevertheless there are still two awesome, unused arrows in the ECB’s quiver.
One of the ECB weapons is the possibility of leveraging the European Stability Mechanism (and/or the European Financial Stability Facility for its residual life) via a banking licence. The government bonds purchased by this/these institution(s) would be used as collateral to borrow from the ECB additional funds to finance further purchases, and so on.
Last December the European Union President Herman Van Rompuy himself suggested that the ESM would be more effective if it becomes a "credit institution." The Germans immediately (WSJ on line, 8/12/2011) and repeatedly afterwards rejected such an idea, with reference to both ESM and EFSF. But it turns out that this is a matter of ECB policy, not subject to a German veto: the ESCB [European System of Central Banks] and ECB Statutes,  Art. 18 on Open Market and Credit Operations, stipulates that:
“18.1 In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may:
— operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals;
— conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral [emphasis added].” And
“18.2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.”
The EFSF/ESM are undoubtedly “other market participants”, and Italian and Spanish bonds are still regarded by the ECB as “adequate collateral”. And it is the ECB itself to establish “general principles” and announce the “conditions” for such transactions. (I am grateful to Carlo Clericetti for pointing this out in a comment to my earlier post and in his article in Repubblica - Affari e Finanza). No German veto can be exercised, Mario Draghi can do it if he really wants to do it.
The second arrow in the ECB’s quiver is the conduct of a monetary policy like the Federal Reserve Quantitative Easing. This has been recommended by many commentators in the past, but of 24/7/2012 reports an article by Federico Fubini in Il Corriere della Sera of the same date.  “According to Fubini, a European QE is not against the EU Treaties, if the ECB would buy governments bonds from every Eurozone countries [emphasis added]. Bank of America-Merrill Lynch also said yesterday that the ECB should start a QE as soon as possible. "It’s a way to change that situation, to break the European stalemate," analysts said.”
The odd thing is that both the original article by Fubini, and the earlier statement by BoA-ML, do recommend Quantitative Easing but make no mention of the alleged compliance with EU Treaties “if the ECB would buy governments bonds from every Eurozone countries”. Maybe this was an after-thought by the Director Wolfgang Munchau, or by another collaborator. In any case, the qualification is brilliant. If the ECB purchases a balanced package of government bonds in the same proportions in which countries hold shares in the ECB, there is no mismatch between the two, and nobody - including the Germans - has any reason to complain. Presumably a satisfactory way of compensating gains (including the capital thus raised by the richer countries) with losses (inflicted by the poorer ones in case of default) could always be settled beforehand.
It is true that the ECB has a capital of only €6bn in the process of doubling over 5 years, but - even setting aside Paul de Grauwe’s powerful argument that a Central Bank does not need equity capital at all - the ECB has off-balance-sheet resources of the order of at least €3.5 trillion being the estimated present value of its seigniorage (see Buiter, 2011).
The existence of such formidable weapons in the ECB armoury does not indicate whether and when they will be used. But the very fact that they might ought to set a limit to the downwards spiral of credit ratings and the escalation of spreads. 
Today Mario Draghi, in London at the Global Investment Conference, declared:  “We are ready to do everything that is needed for the euro. And, believe me, it will be sufficient”… "It is impossible to immagine that a country might exit the Eurozone”, … and “the control over spreads is part of the BCE mandate when they impede monetary transmission mechanisms”. He was not bluffing, and financial markets believed him, bringing Italy’s spread down by over 50 points to below 470 points, and the euro exchange rate up by over 1.5 cents.


Mario Draghi's speech at the Global Investment Conference, London, 26 July 2012. 


Alberto Chilosi said...

I certainly agree and much appreciate the most interesting information of your latest post, but you forgot something important: conditionality. Because of obvious moral hazard reasons the support of the ECB cannot be unconditional. And conditionality involves putting forward constraints to the policies of the supported country. This is a political matter that the ECB may hardly deal with alone. Ideally it should require some collective agreement at the European level (say at the Ecofin level). But would the representatives of the countries to which conditionality is applied agree with a deliberation or a consensus to constrain their policies? Moreover it is against the statutes of EBC to be influenced by opinions or actions of outside political bodies. It seems rather hopeless. But perhaps there is another way: to wait for the indebted country to ask for IMF support (after all the IMF is the specialized international agency for this kind of interventions) and to furnish additional crucial EBC support only to countries satisfying IMF conditionality. Under extreme circumstances the conditionality of ECB could be imposed on its own, at least in some informal way (if I well remember this has already taken place with Italy with the famous letter--cf. and possibly with some pressure for Berlusconi to retire). It may appear rather undemocratic, but in absence of a functioning European federal government it may be the only way out. Moreover it is the function of an independent central bank (such as the EBC) to condition through its monetary policy the myopic behaviour of elected governments anyway.

D. Mario Nuti said...

Good point, Alberto. However, as you suggest, the EBC has informal means of "moral suasion" - like the letter to Italy of 5 August 2011 - and the IMF could be involved providing its own conditionality.

Moro said...

Do you think Draghi's stance was the result of a newly found understanding with the Nordic countries, or the first shot in a new frontal clash with them?

D. Mario Nuti said...

No clash, surely. Draghi's speech had been preceded by the Governor of the National Bank of Austria, Nowotny, suggesting a banking licence for the ESM, which already had brought down the spreads from their peak. And the Dutch were reported to be softening their position. Draghi would not have spoken as he did without having obtained prior extensive support.

But immediately after his speech a Bundesbank spokesman repeated their old position: "no more government bonds purchases by the ECB". This suggests that support for Draghi's position was not unanimous. The important thing is the subsequent re-alignment of Schauble and Merkel with Draghi.

In conclusion, there does seem to be "a newly found understanding with the Nording countries", as you put it. This is the current assessment by financial markets, for spreads have kept falling yesterday.

Enzo said...

Are projects for a Political Union, a Fiscal Union and a Banking Union still necessary to euro salvation, or not?

D. Mario Nuti said...

There is no such a thing as a Banking Union. If you look at any textbook on international economic integration you will not find it in any classification. And there is no need for it, as long as any Union has a proper Central Bank, with functions of Lender of Last Resort (including to governments), banking supervision and deposit insurance. Only when - as in EMU - there is no proper Central Bank, a so-called Banking Union is a patchwork provision of the missing functions.

A Political Union is a fine project, but for the long run, not for next years or for the current crisis. Naturally a Fiscal Union - NOT a Fiscal Pact constraining budget deficits of member states, which is a misleading concept - in the sense of common taxation and expenditure on a significant scale, would be associated to Political Union. Again, a desirable move but not before the next generation and probably later.

Tony said...

"Presumably a satisfactory way of compensating gains (including the capital thus raised by the richer countries) with losses (inflicted by the poorer ones in case of default) could always be settled beforehand."

What do you have in mind?

D. Mario Nuti said...

Suppose the ECB bought a balanced packet of 100bn of EMU government bonds in the same proportions in which EMU countries hold shares.

Roughly 30% of ECB shares are held by 10 EU members who are not EMU members (with the UK at 14.5%), the rest is divided among EMU members: Germany 18.9%, France 14.2%, Italy 12.5%, …, Spain 8.3%, Greece 2%, Portugal 1.75%, , Ireland 1.11%, … Malta 0.06%. Therefore the bond packet bought by the ECB would contain 100/70 or roughly 1.43 times each EMU member’s share in ECB capital, eg Spain €11.869 bn.

Suppose that subsequently Spain defaults and its bonds lose 50% of their value. Germany loses 0.189*0.5*11.869bn euro, or €1.1216205 bn. An equivalent amount out of the €18.9bn outstanding German debt purchased by the ECB could be cancelled, and so on for all corresponding losses of other EMU members.

Non-EMU-member Shareholders would have to be compensated by the ECB for 30% of the loss of value of Spanish bonds, i.e. would have to be paid dividends of 0.30*11.869 bn euro; all ECB outlays to come from ECB profits (including seigniorage if need be, in which case non-EMU members might not be entitled to compensation; I am not clear to what extent if at all they benefit from seigniorage today).

In conclusion, EMU non-members would be compensated for their participation in the cost of Spain’s default with dividends, while EMU members would be compensated by the withdrawal of a corresponding value of their bonds (without prejudice for the present entitlement of non-EMU members to benefit or not to benefit from euro seigniorage).

supermati said...

let's take the bull by the horns!
i still keep wondering why it's not forbidden to ask a country to pay,in some cases,usurious interests.
what shall we do to save the euro?
i also agree that a "flat" interest rate for whole Europe is a good and possible solution. how to achieve? the unique solution is not necessarily the issuing of Euro bonds.
for instance :pretend from investors who want to to invest in euro zone to split their investments otherwise
their are not allow to invest in any of our countries.this way also the poorer countries will get a piece of the cake.

D. Mario Nuti said...

Thanks, supermati [are yoy the Mati I know?]. We had about ten years of euro interest rates convergent on a low rate, until May 2010 when investors realised that country risks were diversified.

Unfortunately the eurozone took advantage of such benefit of the euro by borrowing more rather than converge further. Now the gradual convergence of interest rates will require the parallel convergence of the area fundamentals: debt, deficit, banks re-capitalisation, inflation, trade competitiveness, etcetera.

Something along the lines you suggest (forcing or inducing investors to channel some funds to "peripheral" countries) has already been proposed: if the ECB restricted re-financing to a basket of government bonds including high and low spread countries, this would artificially raise the demand for high spread bonds and lower it for lower spread bonds, thus flattening the differential. It is hard to estimate the quantitative impact of such a stipulation, but it might be fairly small.

Ted said...

Mario Draghi talked up financial markets, but we shall see on 2 August whether the ECB Board will put its money where his mouth was.

D. Mario Nuti said...


By the way, Jan Toporowski tells me that in the 1930s Michael Kalecki argued that the then Reichsbank's ban on buying government bonds in the primary market did not matter providing that the Reichsbank were willing to provide credit to commercial banks to buy the government bonds for them. He came across this while working on Kalecki's intellectual biography. Interesting, and thanks, Jan. The same thing holds today, of course.

Angela said...

"Nor is there any plausible chance of a banking licence for the new rescue fund (ESM) - ie a mega-rescue by the back door. The ECB has already issued a legal opinion killing this idea stone dead. It would require a new EU treaty to lift the ESM’s lending power above €500bn, with fresh ratification in the Bundestag. Forget it.

See. They lie and lie about EU and eurozone reality. Even when it is written in the Treaties in black and white.

D. Mario Nuti said...

It may or may not be the case that granting the ESM a banking licence might require a change in the Treaties. For a banking licence would enable the ESM not only to borrow from the ECB using government bonds as collateral but also to do all the other operations of a bank, like for instance take deposits from the public.

The relevant point is that, in order to borrow from the ECB using government bonds as collateral, and then buy more government bonds and so on indefinitely, the ESM DOES NOT NEED A BANKING LICENCE, which is what art. 18 of the Protocol of ESCB and ECB spells out incontrovertibly.

I am not sure they lie but, if not, they are misrepresenting policy options and either way they are wrong.

D. Mario Nuti said...

An old friend, who has pioneered the idea of Eurobonds for the last twenty years, asks me why I am “so dismissive of Eurobonds as net issues to finance growth, with transfers into the Union from the central banks of emerging economies and sovereign wealth funds rather than transfers within it”.

The fact is that the European Union has 1) a ridiculously small budget, of the order of 1% of the Union GDP; 2) a budget, moreover, which is balanced ex-post thanks to a kind of “income tax” on members’ GDP; 3) and therefore no primary surplus with which to service its own debt. Therefore I expect substantial issues by the EU, or any of its agencies other than the ECB (that is not authorised to issue them) to be treated by financial markets as junk, rather than benefit from the relatively low EU deficit and debt (as proportions of GDP, relatively to the USA). I simply do not believe that the EU could borrow at 2% if it issued such bonds, even from central banks and sovereign wealth funds of emerging countries.

Bond issues for which member states would be responsible pro-rata would naturally have to offer a yield that is a weighted average of national yields, with no net benefit whatever.

The only Eurobonds that would do the job of reducing yields would have to be backed by joint and several responsibility of member states - a particularly risky undertaking for the Nordic countries, that naturally and rightly oppose them.

JDB said...

What is the precise definition of Quantitative Easing? Thanks.

D. Mario Nuti said...

QE is the purchase of financial assets (public and private) by the Central Bank, using monetary creation (eg electronically crediting sellers' accounts and not necessarily printing anything).

m said...

yes, my dear friend:)

we create euro bonds that work like this:
the first part is the same you mentioned before: bonds for which member states are responsible pro rata
and here comes the second part: why should the yield be a weighted average of national yields? we issue ONE SINGLE bond on which two member states appear SIMULTANEOUSLY and everybody is responsible for a HIS amount BUT at different interest rates(but never such with such spread we are experiencing now). so everybody gets credit at reasonable interest rates and no debt is mutualised. the investor is simply forced to invest in "good" country and "bad" euro zone countries if he wants to invest in Europe.
at least as transition measure.

D. Mario Nuti said...

"... everybody is responsible for HIS amount BUT at different interest rates (but never such with such spread we are experiencing now)."

You fail to explain why a country's liability of the same maturity should attract a lower interest rate if it is packaged with another country's liability.

If it were so simple, anybody could construct an equally balanced package of government bonds and sell it at a higher price than the som of the individual components, i.e. a lower yield. Why don't speculators do that? Because, on the contrary, the Eurobond with pro-rata responsibility would yield a weighted average of the yields of national bonds.

It's the law of a single price in each (competitive) market! You must have heard of it!

Rita said...

Yesterday's SPIEGEL ONLINE referred to Draghi's London speech of 26 July as "trivial remarks". Any comment?

D. Mario Nuti said...

Der Spiegel is a conservative, nationalistic paper, ideologically motivated. They can say what they like in a free country, though they may have to eat their words.

The Bundesbank insists on its line "No government purchases from the ECB", but they might turn out to be isolated in the end, rather than Draghi. Schauble and Merkel say "No banking licence for the ESM", but as we have shown there is no need for a banking licence for the ESM to multiply the size of its operations through credit operations.

Tomorrow we will know exactly what the ECB will be able to do.

D. Mario Nuti said...

"Investors had been hoping for a clear signal from Mario Draghi that the European Central Bank was ready to take action to prop up the euro. But in his press conference following the ECB monthly meeting on Thursday, all he offered was more promises. Markets plunged as a result" (today's SPIEGEL ONLINE).

Euro down from $1.24 to under $1.22, spreads up, stock exchanges down, even in Germany.

Maybe Draghi, who had support from Merkel, was not expecting such a strong opposition from the Bundesbank. Or perhaps he thinks the crisis will eventually soften the opposition to radical measures. Or maybe he just follows Greenspan's advice to "keep markets guessing", and lots of fingers are going to be burnt in the near future.

I would bet on the last option (which could be associated with the second) rather than the first option.

D. Mario Nuti said...

"EU Economic and Monetary Affairs Commissioner Olli Rehn said on Friday that financial markets may have initially misunderstood the European Central Bank's decision a day earlier." (Reuters, 2 August).

Initially disappointed (see my earlier comment), soon financial markets have realized that Mario Draghi won the consensus of the ECB Board except for one person, the young, bigot and arrogant President of the Bundesbank ("not only the largest central bank in Europe, but the most important"). Merkel and Schauble, who had supported Draghi's speech of 26 July, later expressed disapproval of granting a banking licence to the EMS, but as we have seen EMS resources can be multiplied even without a banking licence. Draghi did not force an immediate decision on ECB purchases of government bonds, but these would take place later, probably in September (and presumably earlier in an emergency.

A country needing the protection of the anti-spread shield would have to apply for it, but this was part of the original deal. And it is reasonable that the funds of EFSF (though somewhat depleted) and ESM (though not still in force and subject to the German Constitutional Court approval) should be mobilised if possible before the ECB intervenes on its own. And that there should be prior conditions and monitoring of their implementation (better than no funds at any condition).

Which is why after the initial negative reaction markets have recovered: stock exchanges and the euro exchange rate up, spreads down.

So, let us not despair yet - not until the next instalment of the euro crisis.

Jacob Richter said...

Damn, welcome back to the blogosphere, Mario! It's been a long time!

D. Mario Nuti said...

Thanks, Jacob! More soon...