Moderate optimism

The month of January 2015 gave us several, interlocked reasons for moderate optimism about the prospects for economic recovery in the Eurozone and in Italy.

First, the further fall in oil prices, strengthening the trend already present from last summer. From mid-June 2014 to the end of January 2015 the price of crude oil fell by as much as 60 percent, reducing the energy costs of Eurozone producers in spite of the parallel but much lower depreciation of the euro against the dollar (on which more below). Quantitative estimates of the effect of this cost reduction on the rate of GDP growth are uncertain and vary around 0.5% -0.8%, but undoubtedly the positive effect is present and is not negligible.

The second reason for moderate optimism is the ECB decision on 22 January to implement Quantitative Easing, albeit with the disapproval of the Bundesbank president Jens Weidmann and a minority of other representatives of the Nordic  member states of the Eurorozone: € 60 billion per month for 19 months, from March 2015 to September 2016, and if necessary even further, until the Eurozone inflation target "below but close to 2 percent" is reached.  This amount however includes other interventions already decided previously, so that the additional amount really is not €1,140bn but only about €900bn, and the surprise effect (important for example in the Swiss frank large appreciation of 15 January) had been diluted by months, indeed years, of announcements, discussions and debates. However the size of the intervention was still greater than earlier expectations, of the order of €500bn, and therefore there still was some element of surprise. The provision that National Central Banks should take on 80% of the risk of default on 80% of their country’s bonds purchased by the ECB is an important limitation of the Monetary Union but an acceptable price for this massive intervention.

Third, the depreciation of the euro down to a rate of $ 1.11, then stabilized at $1.13 (below the rate of $ 1.17 at which the euro was first introduced and a far cry from its peak of $1.47), for several reasons: ECB Quantitative Easing; the expectation of the Fed raising interest rates, repeatedly announced and now postponed probably to next June; expectations - rightly or wrongly - of the worsening of the Greek crisis and even a possible exit of Greece from the Eurozone (Grexit).  Such devaluation should have a significant impact on the competitiveness of all member countries and therefore their exports and growth, improving the relative position of those who like Italy have seen labour productivity stagnate or even decline over the last decade. Predicting the quantitative impact of euro devaluation on the rate of GDP growth is difficult and risky, but this effect could have an order of magnitude of 0.8-1%.

Fourth, the resounding victory of Alexis Tsipras and his party Syriza in the Greek elections of 25 January, which has called into question the austerity policy adopted by European institutions under the hegemonic influence of Germany as the only strategy response to the Great Recession of 2007, along with so-called "structural reforms".  These last are a euphemism for the dismantling of the welfare state, privatization of under-valued public assets and the cancellation of decades of achievements of the labour movement.

The first moves of the new Greek government were reassuring: Greece has no intention to leave the euro (a choice supported by 60% of the Greek population), nor to press for further cancellation of public debt, nor to request additional aid.  At the end of February Greece expected to receive €2 bn aid from the European Union and €5 bn from the IMF, conditionally on reform implementation.  Now the Greek government requests only €1.9bn from the ECB as reimbursement of the additional interest earned by the Bank on the Greek bonds in its portfolio. As Finance Minister Yannis Varoufakis rightly said, "A Monetary Union responding to a serious financial crisis by granting more loans to deficit countries on condition that they shrink their national income is not sustainable”.  Varoufakis proposes a " menu of swaps " of Greek bonds with new bonds of two types: one indexed to nominal economic growth, whose service therefore would be conditional on the resumption of growth, and the other a "perpetual bond" that would replace the Greek government bonds in the hands of the European Central Bank. The Greek budget would remain in primary surplus, but only on a more modest scale of 1-1.5%, thanks to the decision to pursue big tax evaders.  In this way Greece could effectively honour existing commitments, while creating a fiscal space sufficient to finance the reconstruction of the welfare state, to increase the minimum wage and pensions, as well as to grant the benefits in kind or subsidies (for example in electricity and transport) promised and partly already introduced by the new government.  Otherwise, Varoufakis says, "Greece will become deformed rather than reformed." Varoufakis' plan was received favorably at its presentation to the City of London, and provides an excellent and credible basis for discussions and negotiations with the European institutions.

Why, then, the "moderate" nature of optimism rooted in so many positive developments?

First, the fall in the oil price is the result of lower demand in the recession, the Saudi decision not to cut production to match lower demand, and the significant growth of the US production obtained from bituminous shale.  But the price reduction undermines its causes: not only does it stop investment in the development of alternative energy sources, but at the current price of around $ 50 per barrel it makes most of the production to be sold at a loss and therefore not sustainable. On 30 January the announcement of the closure of one hundred high-cost wells in the United States raised the price of oil by more than $ 8 in a single day although production had continued to rise. And if the low oil price were maintained there would be - and are already experiencing them - negative effects on the demand for imports by oil-producers and therefore on income and employment in the non-oil-exporting countries.

Second, in the opinion of many observers and businessmen, monetary easing by the ECB was "too little too late", in comparison with the $ 4.5 trillion mobilized by the Fed already commenced in 2008, and further, in view of the greater use by US companies of credit and securities to finance investments, compared to the larger component of profit reinvestment by companies in Europe and especially in Italy.  But there is no doubt that monetary easing - in addition to its impact already mentioned on euro devaluation - will facilitate the recapitalization of banks that have an excess of government bonds in their portfolios.

Third, the devaluation of the euro could unleash a war between currency areas with rounds of competitive devaluations, and the associated de-stabilization of financial markets.

Finally, European and German economic authorities have immediately taken rigid and hostile positions adverse to any form of restructuring of Greek debt.

Matteo Renzi has been likened to Alexis Tsipras but unfortunately we are not so lucky, all they have in common is their young age; Italy also has €40bn credits towards Greece, and our excellent Pier Carlo Padoan has neither the imagination nor the tenacity of Yanis Varoufakis.  If anything Alexis Tsipras has something more in common with our new President Sergio Mattarella: immediately after their election both went to visit a monument to the victims of Nazi atrocities, a gesture that cannot have been greeted with enthusiasm by Angela Merkel.  The French are watching from the sidelines; in order to widen the breach in European austerity opened by Syriza we will have to wait for a parallel Podemos victory in the next elections in Spain.

The danger is that the game of chicken played by Germans and Greeks might lead to a lethal crash, perhaps in the form of an "accidental Grexit" (an expression coined by Wolfgang Munchau): the expiry of any deadline before a new agreement is reached, the loss of Greek access not only to Quantitative Easing but also to emergency liquidity provided by the ECB, capital flight and a panic run on the banks by the public seeking to withdraw cash from their accounts.  At that point, a severe liquidity crisis could force Greece to issue some form of national currency, perhaps initially notes issued by the Treasury circulating in parallel with euro cash now in short supply: from there to a formal exit is only a small step. Cyprus came within a breath of this predicament.

Marcello De Cecco noted that while a Greek exit from the Eurozone could very well happen in the way I described, it would be the result of a deliberate policy of not wanting to help Greece, instead of a series of casual fatalities, when there is will there is always a way, and if deadlines are not met this means that Greek exit is not so much feared but wanted.

In any case, a possible Greek exit from the Eurozone – whether accidental or deliberate - cannot be ruled out completely, and would be catastrophic for the entire Eurozone, with contagion spreading first to Portugal, then to the other southern countries including Spain and Italy, eventually turning against Germany itself and the other Nordic countries. That is enough to temper anybody’s optimism.

POSTCRIPT

On 4 February the ECB Governing Board decided that Greek government debt will no longer be accepted as collateral starting next week.  This appears to be like undue ECB interference in Greek negotiations with the EU, but 1) it is well within the Bank’s discretionary powers; 2) it is likely to be part of the price paid by Mario Draghi for the large size of his Quantitative Easing and 3) it is also a way of raising the stakes which might, in the end, favour Greece by raising the cost of a Greek exit for Germany and the hawks as well as for Greece.  After all, Yanis Varoufakis is an accomplished game theorist and should know what he is doing (see Varoufakis Y., Rational Conflict. Oxford, Blackwell, 1991; Varoufakis Y. and S. Hargreaves-Heap, Game Theory: A critical text. London and New York, Routledge, 2004).  At least, this is what we might still hope.

For assessments supporting this last point see the excellent post by Frances Coppola, What on Earth is the ECB up to? and the other posts listed at the end of it.

Europe is a Cow

The Greek etymology of Europa (εὐρυ- "wide" or "broad" and ὤψ"eye(s)" or "face"), suggests that as a goddess she represented a cow (with a wide face). See also Antonio Carracci (b. ca. 1583, Venice, d. 1618, Rome),The Rape of Europe, currently being shown at the exhibition "From Guercino to Caravaggio", Palazzo Barberini, Rome. 

1. Costs and benefits of the Euro

The introduction of the Euro involved for all the EMU member states significant benefits and costs.  Benefits include: a greater economic and financial integration of trade and investment; a rate of inflation lower than the Bundesbank best performance with the DM; and ten years of an interest rate on public debt rapidly converging to a common, decreasing level.

At the same time national governments lost the use of several instruments of economic policy: monetary policy, delegated to the ECB; the nominal exchange rate of the national currency (the alternative “internal” devaluation through lower price and wage inflation than competitors being conflictual and impopular), and fiscal policy now subjected to a much stricter discipline (Maastricht, Growth and Stability Pact, followed by the Fiscal Compact).

Italy had the additional cost of a fiscal squeeze undertaken in order to approach the required pre-requisites – an excellent investment in view of the benefits obtained as a result.  In the transition to the Euro, Italy and Greece recorded an initial burst of inflation caused by the lack of price monitoring and control on the part of the government; this immediately eroded the international competitiveness of both countries, which could no longer be restored through devaluation.  Monetary sovereignty had already been surrendered by the government to the Italian Central Bank in 1980.  A greater financial integration turned into a channel of contagion in the subsequent crisis.  And, above all, on 19 October 2010 in Deauville, Angela Merkel and Nicolas Sarkozy decided that ESM bailouts would inflict losses on government creditors – a position ethically unimpeachable but infelicitous, because it caused a further widening of the spreads of long term interest rates on the public debt of member states with respect to German Bunds.  Thus began the Eurozone tribulations, characterized by stagnation, record unemployment, deflation, still today in the grips of the deepest crisis ever experienced by modern capitalism.

In fact the Great Crisis of 1929 had seen a rapid recovery already from 1933 thanks to the public investment of F.D. Roosevelt’s New Deal, while the crisis that began in 2007 and is still rampaging has been aggravated and prolonged by the perverse austerity policies imposed by International Financial Organisations and the European Union.

2. Euro’s diseases

The Euro suffered from policy errors by various national governments, including the fiscal profligacy of Southern members, but above all from two congenital diseases and a subsequent degenerative disease.

First, the Euro’s premature birth, before political and fiscal integration (and before defence and foreign policy integration): the Euro should have been the very final stage of European integration, its crowning, instead of which it was used to accelerate integration processes, pushing la finalité politique through the tensions generated by monetary dysfunction.

Second, the ECB was born incomplete, not to say mutilated, not so much because of its independence, which is common to the major central banks in the world, but because it was modelled on the Bundesbank, and even more than the latter was totally separated from fiscal policy, without the virtually unlimited power to buy government bonds enjoyed by other central banks otherwise equally independent (as the Fed or the Bank of England or the Central Bank of Japan). Moreover the ECB was born without the usual powers of supervision, recapitalization/consolidation/liquidation of commercial banks, and without the safety net of a common European insurance of bank deposits (the amount nominally insured today is the same throughout the Eurozone, but is the responsibility of national Treasuries, and is therefore worthless in case of a country’s default).

The degenerative disease of EMU has been the progressive economic divergence of member states, not only in terms of monetary and fiscal parameters for which a statutory convergence was envisaged but not observed, but also in terms of other real and financial parameters whose convergence should have been a condition of entrance and continued membership of the Eurozone but was not, such as the unemployment rate, the share of non-performing loans, international competitiveness.  Such progressive divergence created strong and increasing centrifugal tensions.

3. Possible solutions

Monetary policy on its own is not sufficient to re-launch the European economy, in spite of the original and courageous initiatives of the ECB President Mario Draghi (LTROs, OMTs and other unconventional initiatives), also because of the policy constraints imposed by Treaties and/or by the pressures of Northern member states.  It is enough to consider the failure of Japanese policies of Abenomics, i.e. monetary expansion accompanied by modest fiscal stimuli and structural reforms.

International trade, which since the 1970s had been a dominant factor of global economic growth, in the last years has slowed down more than global GDP; the IMF confirms that it has reduced considerably its earlier role in growth promotion.

Many quarters invoke “structural reforms”.  A reform by definition ought to be a change for the better, and a structural reform a significant change for the better, which therefore should be politically uncontroversial and unanimously acceptable. But such reforms raise three serious problems.  There is no agreement on the desirability of this or that reform, in view of their re-distributive effects; any positive effect, if any, can only accrue in the long run (5-10 years); and there are structural reforms that, although clearly beneficial in the long run, in the short run can have strong negative effects. For instance, a competition increase reducing prices today would promote undesirable further deflation; this kind of structural reform is like an investment that although beneficial is not always sufficiently profitable to be recommended.

A reduction of public expenditure in order to reduce taxation (as anticipated but not yet implemented by the Italian spending review) has a positive effect only if it reduces the waste of resources, but otherwise a balanced reduction of both public expenditure and taxation can only have a recessionary impact on income and employment, as demonstrated by Haavelmo.  What might be desirable is an increase of public investment funded by the reduction of current public expenditure.

A superior solution would be a collective large-scale public investment undertaken at the European level. The trouble is that Europe’s so-called virtuous countries, which would be in the best position to undertake a growth-promoting role – thanks to the low interest rates at which they can borrow and their greater margin for fiscal manoeuvre – are stubbornly reluctant to do it.  And the Union budget, at a miserable 1% of European GDP (compared to 20% in the USA), does not allow any large scale initiative.

It might seem that the recent Juncker Plan, with investments of the order of €315bn over three years beginning in the autumn of 2015, represents an important progress in this direction.  But in truth these investments include a presumed and unrealistic multiplier effect on private investments, of the order of almost 15 times.  European Union funds would be only €21bn, of which 8bn diverted from other important uses, 8bn consisting only of guarantees, and 5bn provided by the EIB and unlikely to be fully available without its re-capitalisation.  It is believed that at the moment the funds really available for the Plan are of the order of €2bn – a sick joke (“Europe’s alchemist”, “Laughingly inadequate” The Economist 29 November. See also Mazzucato and Penna, The Guardian, 27 November). 

Jacques Drèze and Alain Durré (CORE 2013) have proposed the issue of bonds indexed to average growth rate of the Eurozone on the part of the ECB or other EU agency, which would then swap them with government bonds issued by member states indexed to national growth rates, in proportion to their share in European GDP.  In such a way the EU agency would be able to insure member states against macroeconomic shocks, paying a subsidy to under-performing states out of the profit made on the bonds of over-performing states, at zero cost.  This is a brilliant scheme, which however in case of default by countries participating in the scheme would inflict serious capital losses on the emitting European Agency.

Pierre Pâris and Charles Wyplosz (2013, 2014) have proposed a scheme called PADRE – Politically Acceptable Debt Reduction in the Eurozone, similar to a proposal of mine of 2013 – consisting in the mobilization of ECB seigniorage for the purchase and retirement of government debt of all countries holding shares in the ECB (including 10 countries that are members of the EU but not of EMU), in the same proportions of the shares they hold.  Therefore even a possible default by a large country would not damage other members and would not involve a Transfer Union.  In his Caffè Lectures of 2011 Willem Buiter estimated the present value of ECB seigniorage at about €3300 billions, but seigniorage mobilization for Eurozone debt reduction is unlikely to be acceptable to the Northern members of EMU.

4. Disintegration of the Eurozone?

Over the last years there has been frequent discussion of the possible disintegration of the Eurozone, with the return to national currencies by the weaker or the stronger members.

The recovery of national monetary sovereignty would allow weaker members the use of all the instruments of monetary policy, and the ability to recover international competitiveness through exchange rate devaluation.  However European fiscal discipline would continue to apply to all EU members even after ceasing to be members of EMU, by virtue of the Growth and Stability Pact.

The initial exchange rate between the Euro and the new national currency would be irrelevant, because the same rate would apply to prices.  But its use as an instrument of economic policy would involve for the weaker members the cost of successive devaluations, higher inflation and higher interest rates, as well as the revaluation of debt; exiting stronger members would face the cost of revaluations making them lose international competitiveness.  All exiting countries would also face the large scale cost of exit from the entire European Union, that requires the single currency as a part of the obligations of membership – the acquis communautaire (except for Denmark and the UK that negotiated a derogation from the Maastricht Treaty before signing it).

Even under unchanged current policies, sooner or later the economic crisis might well come to an end thanks to the automatic mechanisms that always operate in the course of any economic cycle in a capitalist system.  Once the floor of zero gross investment is reached, further falls of investment come to an end, stabilizing national income; at that point net investment is negative and gradually eliminates excess capacity; gross investment resumes first to replace excessive capacity losses, then to exploit the superior technical opportunities accumulated during the crisis; and the ensuing multiplier/accelerator interaction boosts growth further.  Growth revival, however, might happen too late to prevent the disintegration of the Euro (just as it happened with the ruinous disintegration of the USSR and the rouble in 1992).

If this happens this Europe of ours will have betrayed the vision and the values of its Founding Fathers.  And we would not even be able to cry over the inglorious end of the European project because the Europe we have today is no use to us, and it most certainly does not deserve our tears.

[Note: An Italian version of this paper was presented at a Round Table on “Perspective of European Economic Policy”, at the Conference for the Centenary of Federico Caffè’s Birth, Sapienza University of Rome, 4-5 December 2014].

PADRE

The word "Padre" is immediately and inexorably associated in my mind, due to my early Catholic indoctrination, with the utterance “forgive me for I have sinned”.  But these days PADRE is also the acronym for another kind of forgiveness, of part of public debt in Eurozone member countries.  Politically Acceptable Debt Restructuring in the Eurozone is a proposal put forward by Pierre Pâris (CEO and Founding Partner, Banque Paris Bertrand Sturdza, ex-Barings and ex-Morgan Stanley) and Charles Wyplosz (The Graduate Institute, Geneva, ICMB and CEPR), “To End the Eurozone Crisis, Bury the Debt Forever”, VoxEU, 6 August 2013, and in their fuller Special Report 3, Geneva Reports on the World Economy, ICMBS and CEPR, January 2014, launched by CEPR in London on 4 March).  See also Carlo Clericetti, Repubblica.it 15 February 2014.

The PADRE scheme envisages the substantial reduction of Eurozone public debt, say on average by one half of its current level, through the retirement of government bonds by the European Central Bank, proportionally to individual country shareholdings in the ECB, financed through the securitization of shareholders’ entitlement to ECB seigniorage.

[Reminder: The Bank of Italy website defines Seigniorage as “the flow of interest from the assets held against notes in circulation (or, more in general, against the monetary base).” In the case of the Eurosystem, it is included in the definition of “monetary income” which according to Article 32.1 of the Statute of the ESCB and of the ECB is “The income accruing to the national central banks in the performance of the ESCB's monetary policy function. ” (ibidem). The legislation on how the “monetary income” of the national central banks of the participating member states is distributed can be consulted on the ECB website.]
 

Therefore by definition – by benefiting all members proportionally to their shares – PADRE would not imply any resource transfer from any country to another, nor any burden on “virtuous” countries to the advantage of allegedly profligate and undeserving other members (as it would happen by pooling public debt), or associated moral hazard: existing bonds would be replaced by bonds issued and serviced by the ECB on behalf of member countries mobilizing their shares of ECB seigniorage, at an interest rate estimated by Pâris and Wyplosz of the order of 3.5%, only marginally higher than the Bund rate of about 3.3%. This is why such a scheme should be “politically acceptable”, especially since a safeguard clause would stop undisciplined countries from resuming their earlier bad behaviour.  The debt/GDP ratio and the associated spread on public debt would be permanently and painlessly reduced at a stroke.

Pâris and Wyplosz estimate that as a result of this operation Italy’s Debt/GDP ratio would fall from 133% to 80.4%. Beside Italy, only Greece, Ireland and Cyprus would remain above the statutory 60% fixed by the Maastricht Treaty, while Estonia, Latvia, Slovakia and Luxemburg would end up with positive net public assets instead of public debt.  Interest payments would fall not only because of the fall of debt but also because of the lower interest rate charged on new issues. The Fiscal Compact, currently a Damocles’ Sword on many EU countries, would become manageable: in order to comply with it Italy for instance would need a primary surplus of just over 1% for twenty years instead of over 3.5% (one twentieth of the Debt/GDP ratio in excess of 60%).

In order to obtain this result the ECB would have to buy €4,592 bn of bonds, on which it would pay €161 bn interest a year. The trouble is that the two economists estimate average yearly seigniorage revenue at only 1.1 bn, though rising at a steady rate over time. Pâris  and Wyplosz reckon that it would take 50 years before seigniorage could match interest costs. Still, the tangible immediate gains make the proposal a solution preferable to other alternatives considered and rejected by Pâris  and Wyplosz.

-      -- Consolidation through budget surpluses would take, from the peaks reached by the more highly indebted Eurozone countries, a time scale of twenty years, with front-loaded recessionary side effects.

-      -- The sale of public assets, totaling 37% of GDP in the Eurozone, often might be against national interest, would require a massive administrative effort “probably beyond reach”, more time than the two-three years available for it to be effective, and realization prices are bound to be disappointing especially in the recession.

-       --  Classic debt restructuring, deep enough to bring debt down to 60% of GDP would trigger off a bank crisis, for much indeed most of national debt has migrated to commercial banks, whose rescue would require government intervention and more debt; moreover bailouts are no longer available on an adequate scale and, even if they were they would simply add to public indebtedness and make the situation worse. 

-       -- Debt forgiveness would involve a transfer from better-off countries to crisis countries, politically and economically impossible other than perhaps for a single small country.

-       --  Finally, debt monetization in the Eurozone could only take the form of ECB purchases of government bonds, which run up against the same kind of objections as its Outright Monetary Transactions, and in any case leave governments with the burdens of both interest payments and repayment of principal at maturity.

The proposal put forward by Pâris and Wyplosz is a variation of debt monetization aimed at overcoming these drawbacks. I am strongly convinced that the PADRE proposal is excellent. Not least because, independently and contemporaneously, I made a nearly identical proposal in a post on this Blog, on 8 August 2013. 

In that post I took as starting point Willem Buiter’s estimate of the present value of ECB seigniorage, which he defines somewhat more broadly than the definition given above, as the profits obtained from monetary base issues, including the interest obtained from the investment of past issues, plus the anticipated inflation tax i.e. the loss in real value of the stock of monetary base caused by expected inflation, as well as the unanticipated inflation tax. 

This present value of course is not recorded in the ECB balance sheet, but is estimated by Willem Buiter to be of the order of €3.3 trillion (in “The Debt of Nations Revisited: The Central Bank as a quasi-fiscal player: theory and applications”  2011).  I wrote then “Its use to retire a sizeable part of Euroarea members’ debt in the same proportions in which they hold ECB shares would solve the Euro crisis without transforming the Eurozone into a “Transfer Union”, as it would not involve any redistribution across member states.  Potentially inflationary consequences of such an operation could be neutralized by reducing the size of the ECB balance sheet (selling assets and reducing loans), sterilizing monetary liabilities, raising obligatory reserves and raising the remuneration of excess reserves in order to induce banks to keep them inactive”. 

Indeed my own version of the PADRE proposal was put forward in an earlier post, and re-quoted in my post on The ECB firepower of 23 August 2012:

"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 [as ECB shareholder] 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 …)."

"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)."

“So, there is no reason for peripheral (i.e. high spread) eurozone members to panic - yet. Where there is a will there is a way. And financial markets believe in the “Draghi rally”.”

The seed of such an idea came from an editorial comment in Eurointelligence.com of 24/7/2012 (unsigned, perhaps by Wolfgang Munchau?), reporting on various proposals for the ECB to undertake Quantitative Easing like the Fed. The comment noted that a European QE is not against the EU Treaties, if the ECB would buy governments bonds from every Eurozone country [emphasis added]. All I did in my post The ECB firepower of 26/7/2012 (the day of the historical pronouncement by Mario Draghi committing the ECB to support the Euro) is to specify that government bonds from all Eurozone countries should be bought in the same proportions in which they are ECB shareholders, with dividend compensation paid out to other, non-Eurozone shareholders. In such a way there is no mismatch between the composition of ECB assets and liabilities due to Quantitative Easing, and no cross-country transfer is involved.

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 off-balance-sheet resources corresponding to the present value of the ECB seigniorage are undoubtedly large enough to save the euro without invoking Eurozone or EU solidarity.

The existence of such formidable weapon in the ECB armoury does not indicate whether and when it will be used. But the very fact that it might – Willem Buiter always had indicated “quasi-fiscal abuse of the Central Bank” as a likely resolution of the Euro crisis – ought to set a limit to the downwards spiral of credit ratings and the escalation of spreads. 

The only difference between my proposal and the PADRE proposal by Pâris and Wyplosz is minor technicality: in their scheme the ECB buys bonds of a country, then it exchanges them against a perpetual, interest-free loan of equivalent face value, which remains indefinitely as an asset in the books of the ECB but will never be paid back (unless the ECB is liquidated); the counterpart of this operation will appear on the liability side of the ECB’s balance sheet as an equivalent in the monetary base. Pâris and Wyplosz also regard this as non-inflationary in the present conditions of near zero money multiplier, and otherwise envisage that the ECB could raise reserve requirements or sterilize the bond purchase programme by issueing its own debt instruments.

Great minds think alike, pity that nobody listens. Which is why, after describing the equivalent of PADRE, I wrote “However this kind of operation would go against the grain of German and other Nordic members’ monetary conservatism and is unlikely to be undertaken.”   The Karlsruhe German Constitutional Court decision of 14 March, asserting the legality of the European Stability Mechanism against the challenge of 37,000 German claimants, does not yet change the perspective of opposition to any such scheme by the Bundesbank, by its President Jens Weidmann and other German conservative circles. Pâris and Wyplosz seem to be more optimistic. I wish them good luck, wholeheartedly.

UPDATE (05/04/14)

I sent a preview of this post to Charles Wyplosz, Professor of International Economics and Direcctor of the Geneva
International Center of Monetary and Banking Studies, and an old friend. He wrote me a kind and generous e-mail acknowledging our independent development of the same idea, which they intend to mention in their subsequent work on PADRE.

Apparently they now have a forthcoming variant of their scheme that leaves the ECB out of the picture, to assuage German and other Nordic opposition. In that scheme, an agency does the buying, borrowing and swapping in perpetuities while the governments request that ECB sends its seigniorage income to the agency until the costs have been fully absorbed.

There are still a number of loopholes left, of course. “Some are legal but others are economic, including a sharp financial gap in the early decades. The kiss of near-death, though, is that governments must give up seigniorage for decades and, as we all know, governments can renege. We try to stack the cards against that but we will never satisfy those that require a 100% guarantee that it will never happen. “

Charles and Pierre now have some doubt about whether PADRE is indeed politically acceptable. They are “on the road, trying to sell it to officials and central bankers, even including a Bundesbank seminar in May.” Charles believes that there is interest, with strong support in highly indebted countries and no rejection yet in the virtuous countries. At this stage the main problem is that politicians believe that the crisis is over and have zero appetite for solutions to a problem that no longer interests them. Charles tried to place this kind of comment on my Blog but for some reason did not succeed, I am delighted to do it at his suggestion.

Irreversible Euro

“The Euro is Irreversible” - said Mario Draghi at least twice in the last few weeks, both in his 26 July Speech in London, and at the 2 August Press Conference in Frankfurt following the ECB Governing Body meeting. On the second occasion, the ECB President was specifically asked by a journalist: “What is the real meaning of the statement that the euro is irreversible?”

Draghi explained: “There is no going back to the Lira or the Drachma or to any other currency. It is pointless to bet against the euro. It is pointless to go short on the euro. That was the message. It is pointless because the euro will stay and it is irreversible.”

On Thursday 6 September Mario Draghi delivered on his promise. Outright Monetary Transactions (OMTs) are the new instrument being added to ECB powers, without any need for a change in the Treaties, making the ECB all that much closer to the Fed precisely because of its own independence in monetary policy and the requirements of effective mechanisms of monetary transmission.

These transactions involve “unlimited” purchases of government bonds (i.e. without pre-set limits in quantities and time), mostly within the one-to-three-years-residual-maturity range (in place of the earlier programme of bond purchases, now terminated), immediately sterilised, without asserting ECB seniority. And (in cauda venenum) OMTs are conditional on a specific request by a country for EFMS/EMS assistance and the strict monitoring of agreed fiscal policies and structural reforms associated with the programme, under penalty of cessation in case of non compliance.

The spread of Italian and Spanish bonds quickly dropped by over 100 points; the euro strengthened significantly; stock exchanges surged. But by Monday 10 September a new hurdle was placed in Draghi’s path, in the form of an emergency case brought by German MP Peter Gauweiler (and 37,000 other signatories) to the German Constitutional Court to treat the OMTs as a significant change to the EMS already under consideration by the Karlsruhe Court, whose ruling was due the following day, with a view to obtaining a postponement. But the Court promptly rejected the new case, and on 12 September it swept away that final hurdle, as widely and confidently expected, though reserving to a later date the assessment of the implications of OMTs. Spreads, euro exchange rate and stock exchanges resumed their initial response.

"Super Mario to the Rescue" read a New York Times column praising Draghi for his latest plan on Sunday 9 September (and on Monday 10 in The International Herald Tribune), comparing Draghi to “a star soccer player able to dodge through opposition and turmoil to achieve his goals.”


"I prefer to see him as Andrea Pirlo, the Italian midfielder with 360-degree vision, never hurried, always assured, master of the short and the long pass, bane of Germany, a fantasist who hits the target with precision," reads the column.


In particular the columnist Roger Cohen praised Draghi's ability to overcome German opposition to seeing his bond-buying plan come to life, describing how "Super Mario" is able to undo Germany "...with a series of feints that have left hardline Bundesbank bruisers looking as nimble and effective as beached whales"... "Little by little, Mario Draghi, the Italian president of the European Central Bank, has taken an institution whose overriding mission was to keep inflation in check...and turned it into a lender of last resort prepared to throw everything into buying the distressed euro-zone sovereign debt of countries like Spain and Italy and so preserve the euro".

After the European Summit of 28-29 July Mario Monti had been likened to Mario Balotelli, another footballer who also had contributed to the Italian team’s victory over Germany a few days earlier. But Monti’s would have remained a Pyrrhic victory without the subsequent backing of Draghi’s unerring diplomacy and inventiveness, that produced the “Big Bazooka”.

The OMTs have been widely criticised, not only by the usual adversaries of the euro (for instance in the British press, that immediately disparagingly dubbed them On My Tab), but also by respectable, pernickety commentators nitpicking on some aspect or other of Draghi’s scheme.

In his FT column, Martin Wolf argues that a conditional programme of bond purchases is not credible “because the ECB is unlikely to cause a financial crisis the moment a country fails to meet conditions”, by cessation or, worse, reversal of OMTs. But a bazooka can always change its target, trifling with the ECB on conditionality would - of course - be very dangerous; it would be more worrying if there were no penalties, or only lenient ones. Wolf is right, of course, in recommending a more aggressive monetary policy promoting more growth and jobs in the periphery. Since Germany is unlikely to accept this, he concludes that the ECB has only won some time. Even so, for once time comes cheap, and the progress is undeniable.

It has also been alleged that concentration on the short-end of maturities would have no effect on longer and especially 10-year bonds on which the spread over Bunds is measured. Worse than that, investors would sell 10-year maturities to buy those under three years, thus worsening the spread. But the proof of the pudding is in the eating: 100 points fall in the spread as a mere announcement effect is no joke. And the fall in the yield on shorter maturities (capable of rising above longer to signal an imminent danger of default) is usually followed by a yield fall in longer maturities.

We are now confronted with a dilemma, whether to starve because of the austerity imposed by a programme, or to starve because of the high spread (argues Marcello de Cecco, Repubblica A&F of 10 September). But a 100 points fall in the spread, other things remaining equal, frees non negligible resources (the best part of €20bn in Italy’s case) that can be used to stimulate the economy and promote growth.

However, one remaining ambiguity of OMTs is whether the up-to-three-years-bonds would or would not be renewed at maturity. If they were not, this would set a limit, possibly a very serious limit, to the ECB control over monetary transmission mechanisms. But if they were renewed, Mario Draghi could no longer argue that OMTs do not represent debt monetisation. And if they were not, the possibility would return of the spread rising to non-sustainable levels when a country re-attempts market access, or even of failure to access financial markets at any price.

In this case the likely ensuing default would inflict a loss on the ECB, falling fairly and squarely on all of its shareholders (including non EMU members) proportionately to their ECB shares. This could be regarded as a form of genuine mutualisation of the failing government’s debt, without the burden unfairly falling on the richer EMU members as it would be the case with the ill-starred, ill-conceived standard Eurobonds, understood as bonds covered by joint and several responsibility of EMU member states. Importantly the ECB loss in case of default could be covered by the present value of the seigniorage that the ECB possesses in the hidden depths of its balance sheet, all €3.5 trillions in the famous, unchallenged estimate by Willem Buiter (2011).

The ECB Firepower

The idea of multiplying the EFSF/ESM firepower by using purchased government bonds as collateral to borrow from the ECB thus proceeding to buy more bonds, and so on, was firmly rejected by Mario Draghi at the press conference of 2 August after the ECB Governing Body meeting.

Draghi said that he was “a little surprised by the amount of attention that [the possibility of an EMS banking licence had] received in recent press coverage, and in public opinion”… “After all, I have said at least twice that the present design of the ESM does not allow this. It is not up to us to issue a banking licence – this is a matter for the governments. What is up to us to decide is whether the ESM – evenwith a banking licence – can actually be a suitable counterparty that is eligible for central bank financing. And I have said at least twice – at a press conference, and on other occasions – that the current design of the ESM does not allow it to be recognised as a suitable counterparty”  (emphasis added).

Moreover, Draghi referred to “a legal opinion of the ECB on this, which was issued way back [on 17] March 2011”. The Press Conference report actually gave the link to that legal opinion.

Specifically, the ECB legal opinion argues that “Article 123 TFEU would not allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB [European System of  Central Banks]. On this latter element, the ECB recalls that the monetary financing prohibition in Article 123 TFEU … is one of the basic pillars of the legal architecture of EMU both for reasons of  fiscal discipline of the Member States and in order to preserve the integrity of the single monetary policy as well as the independence  of the ECB and the Eurosystem”.

Article 123 of the Consolidated Treaty on the Functioning of theEuropean Union of 2009 (ex-Article 101 of the earlier consolidated version of 2006) stipulates that:

“1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”

Although: “2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.”

The legal merits of the case rest exclusively on the ECB's own interpretation of its own rules, not on a Higher Court or on an “authentic” interpretation. Nevertheless, clearly we must take no for an answer: regardless of the legal position there is no willingness in the ECB Governing Body to transform the ESM into the Lender of Last Resort (to governments) arm of the ECB. Draghi’s rejection of this weapon is compounded by similar declarations by Merkel, Schauble, CDU politicians, the Dutch and the Finns.

What about the ECB acting as an EFSF/ESM agent, within the relatively small EFSF residual budget (about €150bn) and/or - subject to the approval of the German Constitutional Court expected on 12 September - the limited but more substantial ESM (€500bn), with a view to reduce the spread on the bonds of “virtuous” governments?
Here there are more encouraging developments:

1)      On 20 August the Bundesbank Monthly Report confirmed its President’s view that “bond purchases are problematic and lead to risks for stability”. At the same time Jorg Asmussen, the other German representative on the ECB Governing Body, actively and loudly supported “unlimited ECB [government bonds] purchases, for the ECB wants to take out any doubts among market participants about the future of the euro” (Eurointelligence.com, 21 August);

2)      The details on the use of the EFSF/EFM as an anti-spread shield are still under discussion, but the proposal has already been endorsed by Angela Merkel repeatedly over the last month, while the (bad) idea that threshold spread levels would automatically trigger bond purchases has been denied by the ECB;

3)     The credibility of Jens Weidman’s stance has been pre-emptively eroded by the revelation that, back in 1975, the Bundesbank had actually broken its own policy principles and possibly its own statutes by purchasing German government bonds to the equivalent of 1% of its own GDP at the time. (see FT, 7 August, and the excellent piece by Evelyn Harriman of BNP Paribas.

True, the German Central Bank buying German bonds is not the same as the ECB buying Italian and Spanish bonds, but if the ECB bought government bonds of all the EMU member countries, in the same proportions in which they hold ECB shares, re-distribution should not be an issue. As I wrote in my previous post in answer to a comment by a reader:

"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 [as ECB shareholder] 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 …)."

"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)."

So, there is no reason for peripheral (i.e. high spread) eurozone members to panic - yet. Where there is a will there is a way. And financial markets believe in the “Draghi rally”.