Sunday, 6 November 2011

Easing in

A hazard of growing older is that some events that seem fresh and relevant in one's own mind mean nothing to the younger people that one increasingly works with. So it was last week, when RebelEconomist found his forthright initial reaction ("monumentally stupid") to the cut in interest rates by the European Central Bank (ECB) at the first Governing Council meeting chaired by its new president Mario Draghi quoted by a journalist without mentioning the historical context that gave rise to it. When RebelEconomist asked the journalist why he cut out the history, the journalist replied that, since he was only three years old at the time, he did not understand its impact. The purpose of this brief post is therefore to record the historical parallel that prompted RebelEconomist's critical reaction to last week's ECB ease.

The event that last week's ECB interest rate cut immediately brought to my mind was sterling's entry into the European Exchange Rate Mechanism (ERM) in October 1990.

Hopefully even relatively young readers are aware that the ERM was a system of exchange rate pegs, with some limited movement allowed in a band around each peg, between the pre-euro European national currencies, designed to provide a stepping stone on a path from freely floating exchange rates to an irrevocably fixed set of exchange rates that would render the introduction of a single European currency a formality. To maintain their currency's position relative to the other currencies in the system, countries were obliged to either intervene in the foreign exchange market, or if necessary, adjust their short-term interest rates. Short-term interest rate changes ought to affect a currency's exchange value by uncovered interest rate parity such that, for example, raising the short-term interest rate should generate an appreciation of the currency to the point where the probability of capital loss by depreciation balances the extra interest return. Given that Germany's economy was the largest in Europe, the ERM was de facto based upon the deutschmark, and since Germany's Bundesbank had a reputation for keeping inflation low, joining the ERM effectively imposed monetary discipline on its members. If a country ran a higher inflation rate than Germany for long, incipient pressure would develop in the foreign exchange market for its currency to depreciate relative to the deutschmark, and prompt a rise in that country's short-term interest rate to maintain its currency's position in the ERM, which could be expected to suppress its excess inflation.

The mistake that the UK authorities made when sterling entered the ERM was to cut the UK's official short-term interest rate ("base rate") immediately. At the time, given the ruling party's lack of enthusiasm for European integration, financial markets were sceptical about the UK authorities' motives for wanting sterling to join the ERM. It was not hard to see that, with the base rate, used by UK banks to set their mortgage rates, standing at 15%, the imperative for the politicians then in control of UK monetary policy was to lower interest rates. However, with inflation at 10.6% and rising, a base rate cut was difficult to justify without some offsetting factor such as a stronger currency. The British authorities apparently hoped that with ERM membership underpinning the currency, the base rate could be reduced substantially while strong sterling would hold down inflation.

This sceptical market view mattered, not because it represented some character judgement about the UK authorities, but because it shaped expectations about how the UK authorities would react according to the fate of sterling in the ERM, and hence how market participants would be inclined to reallocate money in response. In particular, the suspicion was that the British authorities would be unwilling to live up to their obligation to raise the base rate if and when sterling depreciation mandated it. If so, a sensible trading strategy in the event of sterling weakness would be to sell sterling in anticipation of soon being able to buy it back at a depreciated level after the UK authorities abandoned their commitment to the ERM.

Against such a background, the worst thing that the British authorities could have done would be to feed market scepticism by cutting the base rate hastily (unless a cut was mandated by sterling approaching the top of its band against one or more of the other ERM currencies). Unfortunately, that is exactly what the British authorities did. In fact, they announced a 1% cut in the base rate at the same time as they announced ERM entry, after financial markets had closed on Friday 5 October 1990, and therefore even before sterling had traded in the ERM. Although sterling did appreciate when markets reopened on the following Monday, by the end of the month sterling had depreciated below its peg to the deutschmark even with no further cuts in the base rate. The stage was set for a disappointing time for sterling in the ERM from the UK authorities' point of view, with sterling generally trading in the weak half of its ERM bands, preventing the base rate being cut below 10% despite a dramatic fall in inflation to under 4%, and culminating in the infamous Black Wednesday debacle of 16 September 1992, when despite a reported $27bn of foreign exchange intervention and a 5% increase in the base rate, the UK authorities were unable to hold sterling within its ERM bands and were forced to withdraw it from the ERM.

As a novice central banker at the time, the conclusion I drew from the ERM experience was that, if a change in monetary policy regime removes an obstacle to easing, even if easing can be justified, it is best not to ease at the first opportunity that the new regime presents, especially if the market suspects that the new regime might be softer on inflation. Better to show patience, and prepare the ground for a shift in the monetary policy stance. A delay of a month or so to skip at least one monetary policy meeting should not be a problem, because if the need for easing was that pressing, it would have no doubt been warranted under previous policy regime too.

A similar situation faced Mario Draghi last week at his first meeting of the ECB's Governing Council as ECB President. As an Italian, it was inevitable if perhaps unfair, given Italy's reputation for weak currency and large public debt, that Draghi's commitment to low inflation would be questioned (commenting on Draghi's candidacy for ECB President, the German newspaper Bild wrote "for Italians, inflation is a way of life like tomato sauce with pasta"), notwithstanding some hawkish comments he has made in recent months. In spite of this suspicion about his intentions, Draghi allowed, if not actively encouraged, last week's Governing Council meeting to cut the ECB repo rate – we are told that ECB monetary policy decisions tend to be decided by consensus rather than majority, so we can be sure that Draghi at least did not block the change. Worse, this decision came as a surprise to the market, partly since there was little sign of support for reducing the repo rate from the previous Governing Council meeting on 6 October – according to Draghi's predecessor Jean-Claude Trichet's account of that meeting in reponse to media questions, "the Governing Council found short-term interest rates to be low" - and partly because eurozone inflation presently stands at 3.0%, clearly above the ECB's target of "below but close to 2%". In view of the situation, I would say that Draghi's decision to cut the ECB repo rate last week was a tactical mistake. Draghi's action will have reinforced the market's suspicion that he will be relatively soft on inflation.

Fortunately for Draghi, the impact of his rash interest rate cut on market expectations seems to have been small – medium term (ECB presidents are appointed for a maximum term of eight years) euro area breakeven inflation rates, such as derived from five year German bunds, ticked up only a few basis points on the news. Nevertheless, such inflation expectations represent an average over a wide range of realisations of economic circumstances, and there may yet come a time when eurozone inflation is uncomfortably high, and to get it down Draghi might find it necessary to tighten monetary policy more than an ECB President who was believed to have a stronger commitment to low inflation.

Saturday, 1 October 2011

Naked Hypocrisy?

This is a post RebelEconomist really did not want to write, partly because he has an economic post to finish that keeps getting interrupted, and partly because he dislikes to see personal disputes aired on blogs, but RebelEconomist is angry, so here goes.

In the early, and perhaps more innocent, days of financial blogging, one of my favourite blogs was Yves Smith's Naked Capitalism, which I valued for its links to influential posts and articles elsewhere, and its somewhat more opinionated and entertaining posts than many other analytical blogs. In recent years, however, Naked Capitalism seems to have become increasingly polemical and less analytical, with a bias against bankers, advocates of conservative economic policy and creditors in general. Perhaps encouraged by this tone, Naked Capitalism's commentary has become more vitriolic and dominated by prejudiced, fixated, irrational and often long-winded ranters, with many of whom it is impossible to have a civil, constructive debate of referenced facts and counter-facts, logical arguments and counter-arguments. Even Yves herself, under the strain of the daily grind of the information gathering, writing and technical problems that she sometimes mentions, seems to have become increasingly defensive and curt with critical commenters. Nevertheless, I still do look at Naked Capitalism, and occasionally engageed in the comment discussion when I feellt like a bullfight – with myself as the matador, of course.

A particular feature of Naked Capitalism that began to disturb me was its advertising. Despite the blog's content being rightly critical of the amorality and recklessness of the financial industry, in the UK at least, Naked Capitalism often carried advertisements for some of the most predatory financial businesses. Not wanting to embarrass Yves, I first wrote to her by email three years ago to ensure that she was aware of the issue – manifested on that occasion in an advert for a leveraged property investment scheme – which I supposed might not be evident to her in the US. She thanked me for letting her know, and said that blocking such automatically-placed adverts was possible but would take some time. Therefore, when a year later I saw an advertisement for payday loans featuring an apparently carefree barefoot blonde, which looked incongruous alongside a post praising the Michael Moore film "Capitalism, a love story", it was apparent that Yves had failed to modify the selection of advertisements for her site, so I was less diplomatic and made a comment on the post, pointing out the danger of appearing to be hypocritical. In her response to my comment, Yves made the same point as a year earlier about the difficulty of blocking specific Google ads, and remarking that the income from the adverts was "chump change", which made me think "why not just do without it, then"?

Fast-forward two years, during which I had mostly held my peace about the continued appearance of sleazy finance adverts on Naked Capitalism, until last month, when I was catching up on posts I had missed during a period bereft of internet access, and came across a post attacking payday loans, accompanied by a banner advert for a payday loan firm. The post deplores annualised interest rates on US loans of up to 572%, while the annualised interest rate on a loan from the British firm advertised was 1737%! I left a (perhaps bad-mannered, in which case I apologise) comment on the post and emailed Yves a screenshot of the UK appearance of the post to show her the clash and invite a response to my comment (it being late in the comment thread by then). Again, despite Naked Capitalism having migrated from Google Blogger to WordPress since I first raised the issue, Yves cited the difficulty of rejecting particular adverts. I suggested she might be better to do without financial advertising in general, given that Naked Capitalism's advert placement service seems to select quite a few dubious ones for the UK at least. These also include adverts for IVAs (individual voluntary agreements between debtors and creditors to write off debt, which are very lucrative for the financial advisor arranging them and are therefore aggressively marketed in the UK, but by putting the debtor one step from bankruptcy, leave them in danger of losing their house if they fail to make the reduced repayments), penny stock investment schemes and even advice on using tax havens. Yves responded that she needs the advertising revenue to keep blogging. She justifiably noted that, given the content of her posts, no-one could consider her to be beholden to any of the advertisers.

While I believe that there is no question that the conflict between the content of such a post and its accompanying advertisement looks – and if benefit is derived from the advert is – hypocritical in some way, my mind is genuinely open about whether that hypocrisy matters or is unethical. First, we should be wary of making the tu quoque fallacy; that is, that doing something oneself should not make one's criticism of that action less valid. Second, it could be argued that such adverts are just rogues thrown up by a poorly-targeted advert placement service that should be tolerated for the revenue serving a good purpose that the adverts generate overall. Or even, that by taking money from payday loan firms and tax haven advisers for their adverts to appear next to posts trashing their business cunningly exploits their clumsiness to bleed and undermine them.

Although it would be foolish to accuse a blogger as obviously vehemently against sleazy finance as Yves of tailoring her content to ingratiate such advertisers, there will always be, I think, a danger of being seen to have a conflict of interest when writing opinions about business that is paying you. For example – this is for the sake of argument, not a serious accusation – this week, Yves did not include in her daily links a BBC headline story about the closure of 62 UK debt consolidation firms, for which prominent adverts regularly appear on Naked Capitalism as seen from the UK, on the grounds of their misleading marketing. A more realistic danger is that the author of a blog which makes money from adverts might be tempted to write more opinionated and controversial posts, in a more provocative style, to attract notice and stir up comment, and to post more often to keep readers checking the site, in order to increase traffic to generate more revenue. I have wondered whether this might apply to some other up-and-coming blogs that have begun to take advertising, such as Scott Sumner's Money Illusion blog, which has attracted a lot of attention lately for its radical and controversial monetary policy proposals.

Minded to write a post on the subject of advertisers and blogs myself to raise, in a detached way, these questions for discussion, I asked Yves (respecting the copyright claim which appears at the bottom of Naked Capitalism pages) for permission to use my screenshot showing the juxtaposition of her payday loan post and the payday loan advert to illustrate the hazard involved in accepting automatically-placed advertisements related to the subject of the blog. Despite having claimed to be content with the ethics of taking payday loan adverts, Yves did not give me permission to use the screenshot, questioning my motives for wanting to raise the issue - Yves seems to believe that RebelEconomist is some financial-industry-funded saboteur of blogs like hers. Yves also warned me that writing such a critical post would get me banned from commenting further on Naked Capitalism. Evidently, Yves is no longer as receptive to suggestions of hypocrisy as she was when she wrote in a July 2008 post "On moral hypocrisy", "In my book, a true friend is willing to tell you when you are off base, and that feedback is usually most valuable when you least want to hear it".

Anyway, to this I thought "no problem"; I did not see the post as a priority and would cross the bridge of being excommunicated from Naked Capitalism if and when I came to it. So yesterday, when Yves wrote a post about the hypocrisy of Friedrich Hayek and Ayn Rand (with which, by the way, I am in complete agreement) in calling for the abolition of Medicare and then using it themselves, I could not resist making a comment asking how Hayek and Rand's behaviour in criticising something that they took advantage of differed from Yves' own position on payday loan adverts. However, when I tried to do so, I found that my comment was blocked – I have apparently been banned from commenting on Naked Capitalism even before writing a critical post! I am therefore writing the post now, and being denied use of the screenshot, am providing my own version of Yves' antidote du jour instead for readers' amusement.

Wednesday, 6 July 2011

Right on TARGET

RebelEconomist comes late to this debate, but since it appears to remain active, his views may yet be useful. For what it is worth, RebelEconomist agrees with Hans Werner Sinn's conclusions that the European Central Bank (ECB) is conducting a stealth bailout of the peripheral eurozone economies and that this bailout disadvantages German borrowers, although Sinn's explanation could have been better. The key point, which none of the articles on this subject read by RebelEconomist has made explicit however, is that, because the ECB has set apparently more lenient loan collateral standards than the market for the types of assets that peripheral countries' banks tend to hold, the eurosystem is effectively lending to these banks at a subsidised interest rate, meaning that the eurosystem has become the marginal lender that finances these countries' net euro payment outflows. At the very least, Sinn deserves kudos for raising to public attention such an arcane but significant issue, which had not occurred to RebelEconomist despite his interest in central banking.

In order to judge the arguments made by Sinn and his detractors, it is necessary to appreciate how a cross-border euro payment directly and indirectly affects the balance sheets of the various financial institutions involved. This may be seen by tracing the impact of a typical cross-border payment through the eurozone banking system. Since Sinn was criticised for associating these effects with current account imbalances, I would offer instead a simplified version of his example of an Irish farmer buying a German tractor, in which the payment is exactly the same as it would be for a capital account transaction arranged by the farmer to move his deposit from an Irish bank of questionable creditworthiness to a safer German bank. Suppose that instead of needing to borrow, the Irish farmer, being flush with EU milk subsidies, has enough cash in his bank account to pay for the tractor outright, and just writes a cheque in favour of the German tractor dealer (in the case of deposit flight, the farmer would open a German bank account and write himself a cheque).

This transaction would result in the farmer's Irish bank current account being drawn down and the same sum credited to the tractor dealer's German bank current account, while the Irish bank would make a payment to the German bank via the interbank fund transfer system that settles in their respective current accounts at their central bank.

In most monetary areas, both banks would hold their current accounts at the same central bank, and settlement would involve a simple reallocation of current account credit from the payer bank to the payee bank, with no change in the nature of the central bank's liabilities. In a regionally distributed central bank system, however, like the Federal Reserve System or the Eurosystem, banks deal only with their regional central bank. In this case, the counterpart of the decrease in the payer bank's current account balance, which represents a liability of its regional central bank, is a negative contribution to that central bank's cumulative position with the rest of the central bank system, while the counterpart of the increase in the payee bank's current account balance is a credit to its own regional central bank's cumulative relative position. In the Eurosystem, these relative positions are recorded as balances with the ECB in the interbank fund transfer system TARGET2 (Trans European Automated Real time Gross settlement Express Transfer system 2). In the absence of an existing cumulative position, the farmer's tractor purchase would generate a TARGET2 deficit at the Central Bank of Ireland and a TARGET2 surplus at the Bundesbank.

Because these bank current, or reserve, accounts at their central bank play a vital role in monetary policy operations, how banks accommodate interbank payments depends on how monetary policy is conducted in their currency area. Since these indirect effects are central to the debate stirred up by Sinn, an understanding of monetary policy operations is necessary to evaluate the arguments, so some principles and details relevant to the present discussion are explained here. Readers who believe that they are already familiar with monetary policy operations may skip the following four paragraphs. For a more complete non-technical explanation, refer to the first half or so of my "Easing understanding" post.

Positive balances in banks' current accounts at the central bank represent a secure and liquid asset and are known as "reserves". However, any interest rate paid on reserves is typically relatively low, and is not always paid on the whole balance. Banks therefore usually try to minimise their holding of reserves, subject to a constraint provided either by a ban on overdrafts or by a requirement to hold an amount of reserves representing some minimum fraction (in the eurozone, 2%) of deposits for regulatory reasons, leading banks to aim to hold on average a slightly higher level of reserves than the constraint to allow for the unpredictability of payment flows.

Monetary policy ensures that the aggregate stock of reserves held by the banks is as large as needed, and the banks distribute this stock between themselves via a money market wherein banks with surplus reserves lend to those with a shortage, typically for one day at a time. As any transaction between the banks and the central bank is also settled with reserves, the central bank can use designated transactions to adjust the overall stock of reserves. And because there is, other things equal, a one-to-one correspondence between the stock of reserves and the market-clearing interest rate in the money market (assuming a downward sloping reserves demand curve), the implication is that the central bank can also control that interest rate, and by arbitrage, short-term interest rates generally. In practice of course, central banks generally choose to explicitly set the interest rate rather than the quantity of reserves, as this approach best accommodates the impact of non-policy variations in reserves supply and demand, but note that this equivalence means that it is immaterial to the present discussion whether the central bank uses its transactions to set the stock of reserves or a money market interest rate (contrary to what some of Sinn's critics have argued). The type of transaction that central banks normally use for marginal adjustment of monetary policy is to trade debt; in particular to offer to lend to, or occasionally borrow from, the money market at a prescribed policy interest rate. These are known as open market operations (OMOs). In the eurozone, monetary policy is set by the ECB as the monetary area's central authority, but monetary policy operations are conducted by the national central banks. The policy interest rate is the ECB refinancing rate, charged on week-long loans offered in the ECB's weekly main refinancing operation.

Naturally, if there are significant disparities in creditworthiness between banks, the money market may make allowance for this by requiring less creditworthy borrowers to pay a higher interest rate to compensate lenders for the greater risk of loss. Alternatively, loans may be secured in the form of repurchase agreements (repos) to practically eliminate credit risk. To ensure access to such loans as needed, banks tend to hold some debt securities which are readily acceptable as repo collateral, notably government and government-guaranteed bonds. In a repo, the lender's objective is to take sufficient collateral to make the joint probability of the borrower defaulting and the collateral then being worth less than the value of the loan negligible. It follows that more collateral should be required if the value of the collateral offered is volatile and also that collateral with value that is positively correlated with the fortunes of the borrower is inferior. The conventional way of arranging this is to match the value of the loan with an amount of collateral valued using its market price reduced by some percentage known as a "haircut" specified for that type of collateral, with larger haircuts for collateral with a more volatile market price. Central bank lending is normally collateralised, allowing the central bank to set monetary policy by offering loans at a single rate to all counterparties without discrimination.

Although the importance of monetary policy means that OMOs tend to attract the most attention, the archetypal transaction between the central bank and banks is actually the supply of banknotes. While the aggregate stock of reserves is always greater than zero, in normal market conditions banknotes are by far the largest liability on the central bank's balance sheet, as banks draw down their reserves to pay for banknotes to meet customer demand. This demand for banknotes tends to be fairly stable, typically growing roughly in line with nominal economic activity. The result is that the central bank is structurally a net lender to the money market, regularly renewing its loans as they mature, which provides frequent opportunities to adjust interest rates. Simply renewing less than the full amount of loans maturing would usually be sufficient to adjust money market interest rates upwards; only rarely, between such opportunities, might the central banks need to borrow in the money market to adjust interest rates. As will be explained later, it is this structural central bank position as a lender to the money market that leads Sinn to argue that the size of the "stealth bailout" is limited, on the presumption that the ECB would be reluctant to become a large routine money market borrower.

The reader should now be in a position to appreciate the indirect effects of the payment generated by the Irish farmer's tractor purchase from Germany.

Assuming that the Irish bank had been managing its balance sheet to minimise its reserves holdings, in the absence of any other flows, the payment would leave the Irish bank with less reserves than it needs, because the drain on its reserves is equal to the contraction in its demand deposits and a bank's holding of reserves is typically a fraction of its deposits. The Irish bank therefore might be expected to borrow in the money market to replenish its reserves. The German bank, meanwhile, would be left with excess reserves. In the eurozone, although interest is paid on officially required reserves, no interest is paid on amounts in excess of this; the ECB does provide an overnight deposit facility, but this is intended for emergency use and, at present (since 13 May 2009), yields ¾% less than the refinancing rate. The German bank therefore might be expected to lend reserves in the money market to earn a return on its excess holding. Note, however, that the sizes of the Irish bank's shortage of reserves and the German bank's surplus, though still equal, are a little less than the value of the tractor, because the Irish bank has lost deposits and therefore needs fractionally less reserves than before, while the German bank has gained deposits and therefore needs fractionally more reserves.

Ideally, it might be expected that a bid for funds by the Irish bank at a slightly higher interest rate than generally prevailing in the money market (assuming, for the sake of argument, that money market loans are secured) reflecting its need for reserves, and an offer of funds by the German bank at a slightly lower interest rate reflecting its excess reserves, would be sufficient to ensure that the money market rebalances via a loan from the German bank to the Irish bank. In that case, the payments imbalance arising from the initial transaction would be largely offset by the opposite payment imbalance arising from the subsequent cross-border loan (note that interbank deposits are not subject to reserve requirements), without involving the central bank. From an Irish point of view, the contribution of the tractor import towards a current account deficit would be financed by a capital account surplus in the form of a private sector loan from Germany. Moreover, the contribution of the initial transaction to the Irish and German TARGET2 balances would also be largely reversed.

Since the onset of the financial crisis, however, eurozone money market conditions have not been ideal. The creditworthiness of Irish banks was in question right from the beginning, meaning that their money market counterparties became extra careful to ensure that loans to them were well collateralised. In an attempt to reassure lenders to Irish banks and forestall deposit flight, the Irish government fully guaranteed Irish bank liabilities. Naturally, this undermined the creditworthiness of the Irish state itself, initiating a series of downgrades by the credit rating agencies which prompted the money market to require larger haircuts on Irish government and government-guaranteed bonds pledged as repo collateral. Unfortunately, despite the progress towards an integrated eurozone capital market, there is still a home bias in banks' bond holdings in favour of their own country's government and government-guaranteed bonds. For Irish banks, this has meant that the main repo collateral that they are able to provide is not only less valued in the money market generally, but also less acceptable from them in particular, because its credit risk is positively correlated with their own.

For whatever reason, the ECB treated the financial crisis as a liquidity problem, and chose to continue accepting Irish government and government-guaranteed debt as collateral on much the same terms as before, as if private sector concern about Irish creditworthiness was exaggerated. The result has been that, for any given refinancing rate, the ECB is the least demanding lender in the eurozone money market in terms of collateral requirements to Irish banks. Irish banks have therefore made heavy use of ECB refinancing operations to replace deposits drawn down either by payments for net imports like tractors, or by capital flight. And in the face of this removal from the money market of a natural borrower of their excess reserves, German banks have instead tended to run down their excess reserves by not fully renewing maturing ECB loans. Consequently, TARGET2 payments from Ireland to Germany have on the whole not been offset by payments of loan capital in the opposite direction, implying a growing Irish TARGET2 liability and a growing German TARGET2 claim.

Of course, Irish-German transactions are just one example; the same process has led to generally negative contributions to TARGET2 balances in other peripheral eurozone countries with relatively poor bank and state creditworthiness, notably Greece and Portugal, and generally positive contributions to TARGET2 balances in other countries with payments surpluses such as Luxembourg (which, for its size, has a large banking industry) and the Netherlands. In the absence of a full recovery from the financial crisis, this has led over time to the large TARGET2 imbalances highlighted by Hans Werner Sinn. By offering payment deficit countries' banks loans on terms that do not, if market expectations are rational, fully reflect their higher credit risk, the ECB is effectively subsidising payment deficit countries' borrowing and, since the ECB also provides an alternative outlet for the increases in reserves generated by payment surpluses in other countries, the ECB has become a kind of central counterparty for the eurozone money market, intermediating many of its cross-border loans. The home bias of banks' bond holdings means that to some extent these ECB-intermediated loans are also indirectly funding payment deficit country governments, which also find it difficult to borrow in the international capital market at acceptable interest rates because of their own perceived poor creditworthiness.

As Sinn and other commentators on this issue have noted, interest at the ECB refinancing rate is payable on TARGET2 liabilities and paid on TARGET2 claims, but this is should not simply presumed to be the consolidated national (ie public sector, including the central bank, plus private sector) return for the countries involved. The designers of European monetary union were scrupulous to ensure that the revenue derived from supplying the monetary base (ie reserves plus banknotes) is pooled and shared out between the national central banks following an agreed formula, rather than according to where banks choose to be formally established (and hence which national central bank they deal with), and the geographical vagaries of the demand for banknotes. According to Article 32 of the Statute on the European System of Central Banks and the European Central Bank, the sum of the national central banks' "monetary income" (ie seigniorage) derived from "assets held against notes in circulation and deposit liabilities to credit institutions", less interest paid on reserves and operating costs, is "allocated to the national central banks in proportion to their paid up shares in the capital of the European Central Bank" (ie the "capital key"). For the purposes of this redistribution, the national central banks are required to "earmark" their monetary assets and liabilities according to ECB instructions which specify that positive and negative TARGET2 balances should be counted as monetary assets and liabilities respectively. The monetary income received by a national central bank is therefore independent of the size of its own TARGET2 balance and the interest rate on that balance. In fact, the consolidated national returns on payment imbalances derive from the way in which they are accommodated by private sector banks. Because the payment deficit bank and the payment surplus bank reset their reserves position by borrowing more and less respectively in the ECB refinancing operations, the return to their adjustments is indeed the refinancing rate. As explained above, however, the size of these adjustments is fractionally smaller than the size of the TARGET2 balances because of reserve requirements.

Although the payment deficit countries may pay the same interest rate on their ECB-intermediated borrowing as the payment surplus countries earn on their ECB-intermediated lending, the poorer creditworthiness of the payment deficit countries means that, for them, the ECB refinancing rate is lower in risk-adjusted terms. In the absence of any major bank defaults in the payment deficit countries so far, the subsidy provided by the ECB has been in terms of the expected cost of the credit risk it is bearing without compensation. It is therefore important to know where that risk ultimately lies. As now seems to be well understood by all the participants in this discussion (if it ever was misunderstood), because any losses sustained on ECB OMOs are, like the revenue they raise, shared between eurozone countries according to the capital key, the subsidy is effectively provided by the whole eurozone rather than just the payment surplus countries like Germany. In practice, however, payment surplus countries' share of any losses is likely to be slightly higher than their capital key, because in the event of a major loss, the most vulnerable payment deficit countries might well be unable to bear their share of loss without triggering their own default.

Does the present configuration of TARGET2 balances represent the "ECB's stealth bailout" of the payment deficit countries as Sinn contends? Though a bit polemic, the description is not unreasonable. Firstly, ECB lending is shielding those countries from the full market cost of their accumulated payments deficits. Without ECB lending, to cover its payment deficit in the eurozone money market a country like Ireland would have to sell assets to foreigners at whatever price can be obtained, such as long-term debt or even gold reserves as suggested by Sinn, either to generate incoming euro payments or to raise money to buy safer collateral to support its money market borrowing. This effective increase in the interest rates faced by that payment deficit country would be expected to reduce its domestic demand, for instance for tractor imports, and thereby choke off its payment deficit. And the present ECB policy is not simply a case of monetary easing in response to overall eurozone economic conditions helping the weakest regions most. Because the ECB is more willing to accept the payment deficit countries' government and government-guaranteed debt as loan collateral than the market, and because such debt tends to be disproportionately held by domestic banks, the ECB is effectively charging these banks a preferential risk-adjusted interest rate, in violation of (at least the spirit of) the principle that "the Eurosystem’s monetary policy operations are executed under uniform terms and conditions in all Member States", as stated in Chapter 1 of the Guideline of the European Central Bank. Secondly, while probably not deliberately so, this is also arguably a stealth bailout, because it derives from a technical decision to relax the collateral standards ostensibly for all OMO counterparties rather than accept the implications of lower credit ratings, and the details of how the bailout works are manifestly (ie judging by the protracted debate raised by Sinn) difficult to understand.

Sinn is also correct that the diversion of ECB refinancing towards payment deficit countries is constraining credit creation in Germany. German banks are not constrained in their access to as much base money as they want at the ECB refinancing rate. However, this interest rate is set to meet an inflation objective for the whole eurozone, so to the extent that the relaxation of the ECB collateral rules marginally eases monetary policy in the payment deficit countries, monetary policy must be marginally tighter elsewhere. In other words, the refinancing rate is set higher than it would be if no collateral concessions were made to payment deficit countries. This, given the one-to-one correspondence between the money market interest rate and the stock of reserves, implies less credit creation in Germany. However, considering the present divergence of the strength of economic activity between the payment surplus countries like Germany and the payment deficit countries like Ireland, somewhat tighter monetary policy in the payment surplus countries may well be appropriate.

And as Sinn argues, the size of the stock of ECB refinancing does constitute a restraint on the total size of the TARGET2 deficits. Once the payment surplus country banks have paid down their entire initial share of the stock of ECB refinancing (the liability counterpart to their required reserves then being customer deposits only), it ceases to be possible for them to invest the reserves inflow from payment deficit countries any further in this way. Although the ECB's overnight deposit facility in theory provides an unlimited interest-bearing outlet for excess reserves, the low interest rate offered on such deposits could be expected to prompt payment surplus country banks to either resume lending to payment deficit countries at interest rates they will accept or even to deter unprofitable potential depositors by measures such as by raising bank charges. Either response could be expected to slow the increase in TARGET2 imbalances. Naturally, if the ECB provided a more competitive deposit facility, such as by offering fixed-term deposits at interest rates close to the refinancing rate, this restraint on the TARGET2 imbalances would be removed. Indeed, to meet any further expansion in the payment deficit countries' borrowing at the refinancing rate without easing monetary policy, the ECB would have to borrow money from somewhere.

Finally, assuming that the present chronic TARGET2 imbalances are problematic because the obscure subsidy involved is undesirable, how can they be constrained? Clearly, in a monetary union, inter-regional payments cannot simply be suspended. The most suitable measure would be to withdraw, perhaps in stages, the borrowing subsidy that sustains the imbalances – that is, to bring the ECB's collateral standards in line with those in the market. Thereafter, to avoid a renewed build-up of risk in future, some soft limit on TARGET2 deficits, say as a percentage of national GDP, could be set, beyond which a national government is expected to take some action of its choice to inhibit further increases in its country's deficit. If the burden that this would involve is considered unreasonable for any particular payment deficit country to bear, it would be more appropriate for the rest of the eurozone to explicitly either grant that country's government the money to solve its problem by, for example, recapitalising its banks, or lend that government (more) money at clearly subsidised interest rates, such as via the European Financial Stability Facility.

Addendum on July 12th 2011

To make the relationship between TARGET2 payments and the adjustment of banks' usage of ECB refinancing operations clearer, a numerical example of the changes in the balance sheets of the institutions involved may be helpful. Continuing with the example of an Irish-German interbank payment motivated by either a tractor purchase or deposit flight, Figures 1 to 3 below show the balance sheets of the Irish payer bank, the Central Bank of Ireland (CBI), the German payee bank and the Bundesbank at various stages in the process. Figure 1 shows the situation before the payment is made, Figure 2 shows the effect of the payment alone and Figure 3 shows the balance sheets after the banks have adjusted their reserves position to accommodate the payment. In practice, since day-to-day overdrafts at the central bank are not normally permitted, banks would adjust their reserve position at the same time or even in anticipation of the payment being processed, so Figure 2 is somewhat hypothetical, except perhaps briefly intra-day.

The figures in this stylised example may be taken to be in some notional monetary unit like billions of euros. The German bank and central bank are, in balance sheet terms, about twice the size of the Irish bank and central bank. In the example, the interbank payment represents half of the existing stock of deposits held at the Irish bank. For simplicity, it is assumed that no TARGET2 balances exist before the payment is made. Both private sector banks and central banks have some equity which is invested entirely in securities which could be used as loan collateral as necessary. The only type of monetary asset held by central banks is refinancing loans to the banks. Although banknotes may have originally entered circulation by being purchased by the banks to meet customer withdrawals from their deposits, and were paid for at the time out of the banks' reserves borrowed from the central bank, it is assumed that all banknotes are now held by the public. The banks are subject to a reserve requirement of 20% of their deposits. In case it is not obvious, "secs" is securities, "depo" is deposits, "refi" is ECB refinancing loans, "res" is reserves and "o/d" is an overdraft in a bank's current account at the central bank.

Addendum on December 9th in reply to umarmung: Why debt default need not necessarily lead to euro exit

On 16 November, in response to a comment I made on Olaf Storbeck's Economics Intelligence blog, commenter umarmung asked why I believe that Greece could remain in the eurozone after defaulting on its government debt, and whether banknotes can provide an unrestricted channel for capital flight, as suggested in an FTalphaville post. Since my answer became quite long as I considered it, and since it may interest others who might not read the comments, I include it here as an addendum, rather than in the comments.

Thanks for your appreciation and good questions, umarmung. Sorry to be so slow to reply to your comment. I needed to re-read the information on the inter-regional settlement and banknote management arrangements in the eurozone before I could have confidence in my opinion.

The reason why I say that a eurozone member country which defaults on, or more realistically, restructures its government debt need not give up the euro is that such a credit event does not necessarily disrupt that country's participation in the euro payment system, including inter-district settlement via TARGET2. As described in my post, any change in a country's TARGET2 balance is matched by an incipient change in the reserves liability position on its central bank's balance sheet (Figure 2 in the post). For private sector banks, reserves are an asset, which banks collectively obtain from their national central bank by selling debt (ie borrowing) secured by pledging a sufficient amount of eligible collateral to make that debt effectively credit-risk-free. It follows that TARGET2 balances are credit-risk-free. For example, if trade drains euros from Greek banks to German banks, the TARGET2 liability incurred by the Bank of Greece displaces some of its reserves liability, but the assets exchanged for the displaced reserves remain. As long as the ability of a country's banks to find sufficient eligible collateral to obtain reserves as needed is not impaired by their government's default, that country can remain a fully functioning member of the eurozone. In principle, a eurozone government default need not threaten its country's membership of the eurozone much more than the bankruptcy of one its largest private sector companies.

In practice, however, because of the home bias of EU banks' government bond holdings, especially in the peripheral eurozone countries most at risk of default, a government default is likely to substantially depreciate, if not wipe out, the value of the collateral that its country's banks normally provide for central bank loans. Nevertheless, it may still be possible for the country's banks to carry on making euro payments. If a bank has sufficient capital to cover the loss on its government bond holdings, it may be able to supply supplementary collateral to top up the cover for its loans from the central bank. If the bank cannot provide sufficient new collateral, and cannot repay its loans from the central bank, the central bank is supposed to be able to liquidate the collateral already given by the bank to recover what it owes. Unfortunately though, the ECB's failure to tighten collateral standards and haircuts enough to reflect the true risk of eurozone government defaults means that the central bank is likely to suffer a credit loss in the event of bank failures triggered by a government default. This loss is shared by all the eurozone members in proportion to their capital key, but since the loss is then a bygone, there is no reason why the defaulting country's surviving banks should not continue to use the euro. Government defaults tend to be selective such that the government concerned keeps making some priority payments, and unlike companies, bankrupt governments are not liquidated, so that, if a defaulting government is determined that its country should remain in the eurozone, it may nevertheless be able to find the resources – eg by using its gold and foreign exchange reserves – to recapitalise its banks to allow them to replenish their stock of eligible collateral if necessary.

Of course if, regardless of such mechanisms, depositors do associate government default with withdrawal from the eurozone and the introduction of a weaker national currency, a growing likelihood of default can be expected to prompt capital flight from nominal assets like bank deposits. In that case, the banks have to find sufficient collateral to allow departing depositors to be paid off as long as the run lasts. How much money is required to ride out this run depends on the stock of bank deposits, the proportion of them which are demand or maturing deposits, and how long the run persists. Naturally, if the banks run out of sufficient eligible collateral and even the government cannot provide more, then in effect, the whole country, and not just its government, is bankrupt. Even then, the country could continue using the euro with exchange controls that restricted the value of outgoing euro payments to no more than the value of incoming payments.

I think the issue of banknotes is a red herring. As Clemens Jobst describes in the VoxEU column mentioned by lostgen above on 22 July at 01.04, the balance sheet effects of inter-district fund transfer by banknotes are very similar to those of deposit flight cleared through TARGET2. The small difference is that, instead of a TARGET2 liability (assuming no previous TARGET2 balance), the central bank of the country suffering capital flight, say Greece, incurs an extra liability to the eurosystem to add to that country's allocation of eurozone banknote circulation (equal to its capital key multiplied by 0.92 to allow for 8% of the banknote circulation to be allocated to the ECB itself) to reflect the fact that that central bank has issued more than its share of the eurozone's banknotes. Unless these banknotes are paid into commercial banks, and in turn into central banks, elsewhere in the eurozone, an offsetting adjustment – in their case an asset – appears on each of the other eurozone central banks' balance sheets in proportion to their banknote allocation key. If all the banknotes are paid into the banks and then the central bank of one eurozone country, say Germany, and redeemed, the resulting reduction in that country's net banknote issuance means that its central bank acquires the whole of the offsetting claim on the eurosystem on its balance sheet. I certainly think that the idea given in the alphaville post you mention that "Greece could theoretically continue to issue unrestricted amounts of euro banknotes" to effectively sustain eurosystem funding in the face of capital flight is wrong. Just as they lose reserves when making an inter-district payment via TARGET2, banks have to pay in reserves for the banknotes that they draw, and would still need to pledge eligible collateral when borrowing from the Bank of Greece to replenish those reserves.

It is of course true that, if the ECB permits the government bonds of a dangerously indebted or even defaulted country to be pledged as collateral in eurosystem money market operations, that country can fund itself effectively without limit via the eurosystem by selling its government bonds to its banks which then borrow from the eurosystem using these bonds as collateral at their national central bank. But this would clearly be an abuse of the eurosystem which the other members would be foolish to allow to progress very far, and could stop by either capping or suspending the acceptability of the offending country's bonds as eligible collateral.

Hopefully that explains my remark on Economics Intelligence and answers your questions satisfactorily.

Sunday, 3 April 2011

Principals of subsidisation

When RebelEconomist went to work in the City (of London) in the 1980s, an important perk of most UK financial jobs was a subsidised fixed-rate mortgage. In his case, this benefit was evaluated as the difference between the mortgage rate actually paid to the lender and a specified concessionary fixed rate, and paid with the employee's monthly salary. The lender was not my employer; at the time, this scheme had recently replaced another in which they lent directly to employees at a low fixed rate. For my employer, the new scheme had the benefits of divesting retail lending, which was not their normal business, and detaching them from the loan so that the benefit could easily be terminated without recovering the loan principal if the employee left and limiting their need to be involved in the event that the employee defaulted on the loan. It strikes RebelEconomist that this kind of approach would be a sensible way to tackle the eurozone debt crisis, and he was surprised not to see something similar suggested in the discussion around last week's European Council meeting in Brussels to consider measures to deal with this debt crisis and prevent repetition. This post explains how such an interest rate subsidy offers a better way of tackling the eurozone crisis than the ideas that have been more commonly discussed so far.

While the causes of the eurozone crisis vary over the countries affected, and in some cases stem from private sector uncompetitiveness or indebtedness, the immediate problem the eurozone crisis presents is a sovereign debt crisis. In some countries like Greece, it was the government itself that had accumulated an excessive amount of debt, although to some extent this reflected a weakening of business activity caused by rising domestic input costs and the depressing impact of the global financial crisis on international trade, resulting in decreased tax revenue and increased welfare payments. In other countries like Ireland, the government had been fiscally prudent, but their private sector had borrowed excessively, and to forestall the turmoil of widespread default during the financial crisis, the government chose to either borrow to bail out the private sector or else effectively take over its debts by guaranteeing them. Naturally, any increase in the loan demand from a particular borrower tends to raise the interest rate that the borrower must pay to raise new loans and refinance existing loans as they mature, but debt crises typically also involve a vicious circle as the additional interest expenditure increases the danger that the borrower will at some point be unable or unwilling to keep servicing its debt, prompting an increase in the risk premium payable on that debt. A debt crisis also decreases the market value of any existing fixed interest rate loans made to the borrower concerned and hence increases the implied market yield on that debt, but, before this debt matures, this is a bigger problem for its holders than the borrower.

A standard benchmark interest rate for sovereign debt sustainability is provided by the expected nominal GDP growth rate of the economy – to the extent that the average interest rate paid on the stock of debt exceeds this level, the country must run a primary (ie not including the interest outlay itself) budget surplus just to hold the debt stock at a steady proportion of GDP. If the country fails to achieve a primary surplus this large, its debt burden (as a proportion of GDP) grows exponentially. Depending on a country's perceived maximum politically-feasible budget surplus and expected economic growth rate (allowing for the fact that fiscal tightening tends to depress economic growth in the short term at least), there will be an interest rate above which the country is effectively excluded from the debt market, because borrowing at such rates makes default practically inevitable. For Greece and Ireland, this critical interest rate has been considered to be about seven percent.

Notwithstanding the so-called "no bailout" clause in Article 125 of the Consolidated Treaty on the Functioning of the European Union (TFEU), which stipulates that "the Union shall not be liable for or assume the commitments of...any member state", the more creditworthy eurozone countries are willing to help its more indebted members for various reasons. Ostensibly, the justification for such support may be that one eurozone sovereign default might trigger a cascade of defaults as alarmed investors shun other marginal countries' debt, potentially resulting in the break-up of the eurozone if defaulting countries reintroduce their own, devaluable, currencies. Such a motive has always been arguably consistent with the provision made in Article 122 for "Union financial assistance" to a member state in "difficulties...beyond its control", but it is now specifically permitted by Article 136, which was amended at the December 2010 European Council meeting to allow eurozone member states to establish a "stability safeguard the stability of the euro area as a whole". In reality, the more creditworthy countries may also be acting in their own self-interest because their banks and pension funds are the troubled countries' creditors.

An obvious way for the creditworthy countries to help the indebted countries is to reduce their interest rate expense. The creditworthy countries could achieve this either by lending them money at sub-market interest rates or by paying the indebted countries compensation for their excess interest costs, but it is conceivable that just credibly showing the willingness to support the indebted countries in some way may be sufficient to cut out the vicious circle that raises the risk premium on their debt, in which case actual assistance might not be needed. To date, as far as RebelEconomist is aware, every assistance scheme that has been used or suggested involves the creditworthy countries lending to the indebted countries directly or indirectly via supranational lending institutions, and thereby taking on the risk that the indebted countries will fail to repay the principal they have borrowed.

Assistance from EU governments and the IMF has so far taken the form of emergency lending to the indebted countries in the event that the market cost of loans to them is deemed prohibitively expensive. The first eurozone emergency loan package was a €45bn three year loan facility for Greece, comprising €30bn in bilateral loans from the (then) 16 eurozone member states and €15bn from the IMF (and therefore partly representing a further indirect loan from all 27 EU member states as well as the other members of the IMF), agreed on April 23rd 2010. Since this amount appeared to be insufficient and failed to stem the rise in Greek government bond yields, it was quickly enlarged to €110bn (split 80:30 between the eurozone countries and the IMF) on May 2nd even before it began to be drawn down by Greece on May 12th. A €750bn loan facility to cover subsequent eurozone emergency lending was introduced on May 9th 2010. This comprises a mixture of loan commitments of up to €250bn by the IMF, €60bn from the European Financial Stabilisation Mechanism (EFSM) and €440bn from the European Financial Stability Facility (EFSF). The EFSM is a loan facility, provided by the European Commission and therefore backed by all 27 EU member states, which borrows the money it disburses in the international capital market (which it is readily able to do as the EU is rated as a triple-A borrower by the major credit rating agencies). The EFSF is a limited liability special purpose vehicle (SPV) owned and severally guaranteed by eurozone member states to 120% of its lending capacity (to ensure its own triple-A rating), which also funds itself in the capital market. On November 28th 2010, Ireland became the first country to take a loan from this facility.

The EFSF is to be replaced in 2013 by the European Stability Mechanism (ESM), another SPV. Although full details have yet to be agreed, it is planned that the ESM will lend up to €500bn and also differ from the EFSF in that (1) its loans to eurozone countries will formally rank above other unsecured loans in the creditor hierarchy and (2) that it will be backed by capital rather than guarantees. Most of this capital will, however, be callable; the difference between callable capital and guarantees being that eurozone countries would be required to pay additional capital into the ESM as the likelihood of loan defaults rises, rather than after a default has occurred.

Enthusiasts for closer European union are wont to see a crisis like the present eurozone crisis as an opportunity to advance solutions involving increased integration. An example is the proposal to extend the EFSF/ESM SPV to borrow on behalf of all eurozone countries as a centralised funding mechanism issuing "euro bonds" and on-lending to each eurozone country as required. Depending on how this European Debt Agency (EDA) was capitalised and/or guaranteed by the eurozone member states and therefore rated by the credit rating agencies, and depending on whether different countries were charged different loan rates according to their creditworthiness, this scheme could be used to subsidise the borrowing of the less creditworthy countries like Greece and Ireland, at the expense of the most creditworthy like Germany and the Netherlands. However, there might be a collective gain if the EDA was able to issue larger and more homogeneous bond issues with a price premium reflecting their greater liquidity.

Another way of ensuring that a borrower is able to obtain funding at an acceptable interest rate is to buy up the borrower's existing debt in the secondary market to hold its market interest rate down so that the borrower can issue new debt at a similar yield in the primary market. In conjunction with the May 2010 IMF/EFSM/EFSF loan package, on May 10th the ECB announced the Securities Markets Programme (SMP) to buy government debt of those eurozone countries with escalating yields, although the ECB somewhat incredibly presented the SMP as a measure "to ensure depth and liquidity...and restore an appropriate monetary policy mechanism". The details of the SMP regarding which countries' debt to buy, how much and at what yield triggers, are left to the discretion of the ECB's Governing Council, but all purchases are funded by reducing collateralised (ie virtually risk-free) open market monetary policy lending to the market in order to sterilise the SMP's impact on the monetary policy stance. Since the eurozone countries capitalise the ECB, the SMP is also effectively backed by callable capital from the eurozone states, and indeed the ECB subsequently did call for additional capital on December 16th 2010.

To relieve the ECB, it has been suggested that the EFSF could buy troubled eurozone government bonds, either from secondary market counterparties or from the ECB to allow it to reduce its exposure to risk. Alternatively, the EFSF could lend to the indebted countries to allow them to buy back their own debt. Since this debt trades well below par in the secondary market, such repurchases funded by new loans would certainly reduce the nominal value of a borrower's outstanding debt, and if the loan from the EFSF is at a concession to market yields, the borrower's interest rate expenditure would also be reduced.

At an informal summit on March 11th 2011, euro area heads of government concluded that the the EFSF and ESM could buy government debt in the primary market in exceptional circumstances. While this is effectively the same as direct lending to the borrower, if primary market intervention is done in conjunction with an issue partly sold or at least offered in the market, it can ensure that the interest rate charged bears some relation to market rates.

In general, these assistance operations are undertaken subject to various conditions imposed on the borrower which ought to make default less likely, but the problem remains that, once the capital has been committed either by being transferred or pledged as callable capital or by guarantee, it is at risk of loss. Direct lending only helps the borrower if the interest rate charged is less than the rate that the market would charge, and unless the lenders are prepared to incur some (expected) cost to themselves to help the borrower, lending at sub-market rates can only be justified from the lenders' point of view if market interest rates exceed the level required to compensate for the risk of default. Similarly, buying debt in the secondary market to hold the borrower's market interest rates down is only cost-free if the market price overestimates the probability of default loss. Considering that some respected analysts consider that Greece and Ireland at least are practically insolvent, despite being assigned credit ratings several notches above the minimum (S&P presently rate Greece as BB- and Ireland as A-), it is not easy to argue that their market yields are unrealistically high. And to the extent that buybacks raise the market price of debt, they give the existing holders of the troubled debt a way out of their exposure with a windfall gain (relative to the pre-buyback value of their holding). Naturally, debt market intervention means that market prices no longer provide an undisturbed guide to market expectations of default losses. Also, if a loan or buyback has proved successful at averting an immediate debt crisis and it is unlikely that further intervention will be required in the near future, having secured concessionary funding the borrower may be less motivated to maintain the austerity required to avoid default.

To RebelEconomist, it seems that a debt subsidy payment scheme like that offered by his former employer could both insulate the creditworthy countries from default losses and give them more control over the assistance they are providing to the indebted countries. Instead of making occasional large capital commitments as loans are disbursed or buybacks are executed, the creditworthy countries would make a stream of relatively small transfer payments to compensate the indebted countries for whatever is deemed to be the excess interest expense on new borrowing from the market. According to the scheme's objectives and constraints, in each case the concessionary interest rate might, for example, be set at a level believed to make the indebted country's debt burden manageable or to match the benefactor countries' funding costs. Given this concessionary interest rate, and the average yield on bonds similar to those to be issued, the size of these subsidising payments can be estimated from sovereign borrowing forecasts. For example, if Portugal is expected to issue €20bn of debt in the next year, and its excess (eg over comparable German bunds) market yield is deemed to be 5%, a payment of €1bn is sufficient to subsidise Portugal's interest cost arising from next year's issuance down to German levels (although of course such payments would grow as long as yields remained at crisis levels). Subsidy payments could be readily adjusted according to the progress of the programme for a particular indebted country, including being suspended if that country stopped servicing its debt or failed to comply with the conditions attached to the scheme, or more optimistically, its economic performance improved so that assistance was no longer needed. Since the subsidy can be curtailed at any time, such a scheme is arguably more in line with the no-bailout clause in the TFEU, because it does not involve the EU or any member state "assuming the commitments" of another member state. This controllability should also make a subsidy payment scheme more acceptable to the benefactor countries' electorates than lending to the indebted countries. Finally, because the scheme would not involve taking over credit exposure from the debt market, indebted country bond yields would serve as a better guide to investors' expectations of default, and loans would not be made at all unless they seemed likely to be repaid.

A likely objection to a subsidy scheme might be that it involves actual fiscal transfers from the creditworthy to the indebted countries, whereas loan capital and guarantees provided via supranational institutions like the ECB and the EFSF do not, but this would be disingenuous – unless market yields really do overestimate the probability of credit losses, loan capital and guarantees can be expected to generate losses in excess of any acceptable interest rate premium charged on EFSF/ESM loans over its cost of funding. Unfortunately, however, unless such probabilistic losses seem likely to be realised within the terms of office of the politicians deciding how to tackle the eurozone crisis, they are likely to be ignored.

Tuesday, 1 March 2011

Setting the record curved

Although RebelEconomist has always been sceptical about the more alarmist views of the global economic slowdown, he was unconvinced by Reuters' columnist John Kemp's argument, as reported by FTAlphaville, that rising commodity prices indicate that there is little or no output gap at the global level. The explanation given by John Kemp is that a negative output gap does exist in the advanced economies, but is largely offset by strong growth in emerging economies such as China. And since FTAlphaville's bloggers were enthusiastic about the idea, and seem set to refer to it again and again in future posts, RebelEconomist presents his own analysis here, which shows that a more sophisticated time-series estimate of the output gap does suggest that an output gap exists at the global level.

Briefly, the output gap theory is that actual output can differ from the potential output given by the productive capacity of the economy, and that this gap affects inflation. Most commonly, actual output falls short of potential output, in which case the output gap is defined as negative, and producers tend to mark down prices in an attempt to stimulate more demand to take up the slack. Such situations typically arise from deficient demand, in response to which producers can leave some fraction of their capacity, including both labour and equipment, unused or under-used. Actual output can conceivably also exceed sustainable potential output by measures like paying workers overtime to take less rest and postponing routine maintenance of equipment, although producers' ability to do this is limited by the tolerance of their existing workers and equipment, meaning that such a positive output gap cannot grow large or last long. During such periods when the output gap is positive, producers can be expected to mark up their prices to recoup their additional costs, which naturally chokes off some demand.

For most countries, actual output is either counted directly or can be estimated reasonably accurately from related observations such as electricity production, but by its nature, unused productive capacity is harder to observe. Given good economic statistics and knowledge of the economy-wide production function, it is possible to deduce productive capacity from surveys of the factors of production including labour and capital. A less demanding and commonly-used method is to estimate the output gap from the time-series of observations of actual output. On the assumption that macro-scale economic capacity grows steadily, potential output can be estimated by fitting a trend to the path of output, perhaps excluding the observations covering dips in actual output associated with economic slowdowns, but not excluding the peaks if positive output gaps are considered negligible (indeed, sometimes the trend is obtained by fitting a curve through the peaks only). The divergence between that trend and actual output, or to be more precise in graphical terms, the length of a vertical (ie parallel to the output axis) chord between them, is then taken to be the output gap. During an ongoing negative output gap, which is unfortunately when interest in the output gap is likely to be greatest, potential output has to be estimated by extrapolating the trend to the end of the series, which is a more ambiguous procedure than bridging a trough in the middle of the series.

There are at least two weaknesses with this output gap approach to assessing inflationary pressure. First, the assumption that potential output varies smoothly seems heroic. Obviously, disasters such as war or earthquakes can wipe out large parts of industry at a stroke, but more subtly, productive capacity constructed and organised to suit a particular understanding of the state of the economy may be rapidly rendered obsolete if actual events falsify that view. The latter scenario is arguably applicable to the present post-financial-crisis period, with the crisis itself arising as people in various developed countries with current account deficits realised that the course of debt-financed consumption growth that they were on was unsustainable, not least in the face of growing competition for resources from the developing countries. This account has been popularised in the blogosphere by Arnold Kling as a "recalculation", but has roots going back at least as far as the "malinvestment" concept of the Austrian school of economics. Clearly, if the productive capacity of the economy can in fact undergo a sharp contraction, a trend-fitting approach will yield an overestimate of the (negative) output gap for such periods. In other words, the slowdown in economic activity would reflect structural factors rather than deficient demand, implying that any attempt to boost demand to take up the estimated spare capacity will just drive up prices. Second, the economy-wide relationship between the size of the output gap and its influence on inflation of the general price level may well be complex, perhaps allowing rising prices in some bottleneck industries, such as commodity production from Earth's finite resources, to coexist with reported spare capacity in other activities and hence in the economy as a whole.

In an expanded analysis emailed to Reuters' clients (which does not seem to be freely available on the web) John Kemp presented a chart of advanced, emerging and world economy industrial production from the monthly World Trade Monitor published by the Netherlands' Centraal Planbureau (CPB). From this, he inferred, apparently by visual inspection with some kind of linear extrapolation of the recent trend in mind, that emerging economy output is roughly on trend and advanced economy output is catching up, so that, as he put it, "for the world economy as a whole, the output gap is probably small or non-existent".

This inference is based on a kind of optical illusion. The chart of CPB industrial production data (to be precise, the volume of industrial production excluding construction, expressed as an index based on the average level of industrial production over the year 2000) is reproduced below.

Here, global industrial production is calculated as a weighted sum of advanced and emerging economy values, where the weights are given by their shares of world production in 2000, comprising 65.1% and 34.9% respectively. First, as is evident from all three time-series, while there are inflections in output growth, it is an essentially exponential process. This means that a linear extrapolation of the trend to the end of the series fails to capture the characteristic steepening of the trend as time progresses. When exponential trends are fitted to the relatively stable growth of all three series in the five years prior to the onset of the financial crisis (taken to begin with the demise of Bear Stearns in March 2008, hence the trends are fitted over the period March 2003 to February 2008 inclusive), as shown in the chart, it is clear that actual output remains divergent from trend right up to the end of the series (December 2010). Second, because emerging economies are growing faster than advanced economies (their fitted trends grow at annual rates of 9.5% and 2.5% respectively, with world industrial production expanding at 5.4%), the emerging economy trend is steeper at the end of the series, implying, for any given parallel separation between the trend and actual path of output, a longer vertical chord between them and hence a larger output gap.

By my reckoning, in December 2010, even the emerging economies had a (negative) output gap representing 16.7 output index units or 7.2% of trend output at that time, while for advanced economies the output gap was 17.6 output index units or 14.9% of trend. And naturally, when the smaller but nonetheless significant output gap in the emerging economies is weighted by their relatively small share of world production, it does little to mitigate, let alone offset, the larger output gap in the advanced economies, so that it is clear that a sizable output gap does exist at the global level. Based on the trend fitted to the world output time-series directly (rather than being constructed from a weighted combination of the trends for emerging and advanced economies), the output gap at the global level is 15.1 output index units or 9.7% of trend. In conclusion, while it is possible to debate the validity and significance for inflation of time-series output gap estimates generally, fitting a realistic trend to recent years' output observations for the advanced, emerging and world economies rather than judging the trend by eye, and carefully measuring the gap between that trend and the actual observations against the output scale, strongly suggests that an output gap does presently exist at the global level.

Wednesday, 6 October 2010

More like zip than ZIRP

Yesterday's monetary policy easing by the Bank of Japan was presented in some press reports and blog posts as a return to the zero interest rate policy (ZIRP) that Japan tried from 1999 to 2000, and again from 2001 to 2006. No doubt the press were guided by the official post-decision statement, which described the policy as a "virtually zero interest rate policy". RebelEconomist is not convinced.

To be precise, the new policy is to guide the inter-bank uncollateralised overnight call rate to a range of "0 to 0.1%", compared with its previous target of "around 0.1%" maintained since December 2008. However, as footnote 2 of yesterday's statement states, the interest paid on excess reserves under the BoJ's complementary deposit facility (originally introduced in October 2008) remains at 0.1%. As described in detail in an earlier post here, paying interest on reserves effectively sets a floor to interest rates in the inter-bank market, because it pays any bank with a reserve account at the central bank to accept loan offers below the interest rate paid on reserves and deposit the money with the central bank. Depending on the significance of inter-bank market participants without access to remunerated reserves, transactions costs and operational constraints (such as timing differences between the close of the inter-bank market and the latest transactions allowed with the central bank), arbitrage should not permit inter-bank interest rates to fall much below the rate paid on reserves. And indeed, a US Federal Reserve study of foreign central banks' experience with remunerated reserves by Bowman, Gagnon and Leahy published in March 2010 found that since the complementary deposit facility was introduced in Japan, the overnight call rate had never traded below 8 basis points. This suggests that yesterday's BoJ policy change represents a negligible easing in terms of short-term interest rates.

There was also another easing measure announced by the BoJ yesterday. The BoJ undertook to purchase outright ¥5tn (about $60bn) of longer-term government and shorter-term private sector bonds including commercial paper (CP), asset-backed commercial paper (ABCP), corporate bonds, Japanese Real Estate Investment Trusts (J-REITS) and exchange-traded funds (ETFs), partly to reduce term and credit/liquidity spreads respectively, and partly of course to supply additional base money in pursuit of the lower overnight call rate target. Of this ¥5tn, "about ¥3.5tn" ($42bn) is to be allocated to government bonds and treasury bills, and only "about ¥1tn" ($12bn) to CP, ABCP and corporate bonds. Compared with the BoJ's existing holdings of JGBs (presently ¥80tn or $960bn), the outstanding stock of JGBs (¥734tn or $8.3tn as of end-June 2010), or the total size of the Japanese bond market (about $12tn or ¥1100tn according to the BIS as of end-March 2010, of which $9.8tn comprised JGBs) the planned purchases represent modest amounts. A rough estimate of the likely effect on yields of these additional acquisitions can be derived by comparison with the estimated effect of the Fed's treasury purchases under its own quantitative easing program, as the size of the US treasury market ($10.0tn at end-March 2010) is of a similar size to the (then) $9.8tn JGB market. According to a recent Federal Reserve discussion paper by D'Amico and King, the Fed's purchase of $300bn of treasuries in 2009 generated a sustained fall in mid-curve treasury yields of about 50bps. Assuming a similar impact of BoJ purchases on the JGB market, the $42bn JGB purchase announced yesterday could be expected to reduce mid-curve yields by about 7bps only.

Overall therefore, yesterday's BoJ easing move is modest, and may have been designed as much as a concession to the BoJ's critics in government and industry as an attempt to stimulate the Japanese economy.

Monday, 26 July 2010

We had to burn the euro to save it

An edited version of the following commentary on the eurozone debt crisis appears in the latest edition of a magazine for official monetary and financial institutions and the original is posted here by kind permission of the publishers.

Faced with a sovereign debt crisis that threatened to spread from Greece to at least Portugal and Spain, between March 25th and May 10th of this year the eurozone authorities progressively relinquished various constraints designed to maintain the ECB's solvency and detachment from fiscal policy. While the authorities' aim was to avoid a collapse of EMU as members unable to remain competitive and service their debts in euros seceded from the monetary union to reintroduce their own national currencies, the adjustments threaten to undermine the real value of the euro by weakening the ECB's balance sheet and setting precedents for similar accommodation in future. After this U-turn, investor perceptions of the euro may never be the same again – the euro may remain the currency of most EU states, but as a unit diminished in value and reputation.

The euro was conceived as a hard currency. Part of the motivation for EMU was the desire of Germany's EU partners to emulate German post-war economic success, which owed much to a hard Deutschmark that drove German industry to seek real solutions to problems like the 1970s oil shocks, rather than the inflation and devaluation palliatives tried by other European countries; Germany itself would have refused to join any less rigorous monetary union. And until the present eurozone sovereign debt crisis, the ECB had largely followed the Deutschmark model. In its first few years, the ECB withstood scepticism about an initially weak euro, and resisted calls from politicians like Oskar Lafontaine to use (the short-run ability of) monetary easing to boost economic activity. Although the ECB did cut euro short-term interest rates in response to the early (US sub-prime) phase of the global financial crisis and offered eurosystem banks unlimited loans against private sector bond collateral for periods of up to a year, unlike the US Federal Reserve the ECB declined to drive inter-bank interest rates to practically zero or purchase such bonds outright for its own balance sheet. Indeed, until this year the euro was gaining ground as a reserve currency as the more accommodating stance of the Fed and the ongoing deterioration of the US net international investment position raised doubts about the future value of the dollar.

Unfortunately, the spreading of the financial crisis to the debt of eurozone governments, especially those of Greece, Ireland, Portugal and Spain, proved to be a sterner test of the ECB's resolve. These countries had got into trouble because, since adopting the euro, they had not taken advantage of its lower interest rates to reduce their borrowing while failing to reduce their labour cost increases in line with the lower inflation of the eurozone. Even countries like Spain which had not run increased public sector deficits during the good times came to face fiscal problems as their economies were depressed by private sector debt and uncompetitiveness. This situation poses an existential threat to EMU, because one way for a member of a monetary union to tackle such difficulties is to secede from the union and reintroduce a national currency that can be devalued to reduce the real value of domestic debt and restore the competitiveness of domestic output. Obviously, this is bad for the holders of that debt, and to the extent that secession of one country makes it seem more likely that others will follow, investors will demand higher interest rates to hold those countries' debt, encouraging them to secede and so on, collapsing the monetary union through a cascade of withdrawals. Understandably therefore, the ECB may have been more inclined to acquiesce to measures to hold down marginal countries' bond yields and to err on the easy side in monetary policy to minimise their incentive to secede from EMU.

The first concession made by the ECB was in the collateral requirements for its lending to eurosystem banks. These were set in terms of agency credit ratings, no doubt to distance the ECB from the task of differentiating between the creditworthiness of eurozone governments, with the inevitable consequence that a credit rating agency decision could render a country's debt ineligible as ECB collateral at an inconvenient time. In particular, the likelihood that that Greek government debt would be downgraded below the ECB's normal A- / A3 threshold threatened to restrict the ability of Greek banks to borrow from the ECB and would have removed a key benefit supporting the value of Greek government debt. On March 25th, however, ECB President Trichet said that investment grade (ie down to BBB- / Baa3) debt would be accepted for an indefinite period. And then on May 3rd, with the prospect looming that Greek government debt could even be downgraded to junk status, it was announced that Greek government debt specifically would be accepted regardless of its credit rating.

The most shocking climb-down by the ECB, however, occurred on the night of May 9/10th, when in association with the creation by EU finance ministers of a €750bn emergency funding mechanism available to any eurozone country, which added to a €110bn conditional loan facility for Greece agreed on May 2nd, the ECB announced an outright bond purchase programme. Since the ECB had previously consistently resisted appeals to follow the Federal Reserve, Bank of England and Bank of Japan in buying bonds to enhance monetary policy easing, this change raised questions about both the ECB's commitment to inflation and its political independence.

Although the ECB presented this Securities Markets Programme (SMP) as a technical initiative "to ensure depth and liquidity in those market segments which are address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism", the SMP does potentially compromise the ECB's ability to hold down inflation in future. The concern is not so much the money-creating effect of government debt purchases, as the ECB undertook to sterilise this by introducing a week-long deposit facility (actually, given an unchanged interest rate target, routine open market operations effectively provide automatic sterilisation anyway), but rather that the SMP effectively represents an additional source of funding for eurozone governments. It is normally undesirable for a central bank to lend to its government partly because that government may be tempted to borrow and spend more than otherwise in the knowledge that, if the volume of its debt sales disturbs the market, the central bank provides a backstop, and partly because the accumulation of potentially depreciating assets on the central bank's balance sheet may restrict the central bank's ability to sell enough assets to absorb excess money to counter an inflationary threat. For these reasons, Article 123 of (the updated version of) the Maastricht Treaty specifically prohibits the ECB from purchasing debt directly from eurozone governments, and buying government debt from the market to relieve a surfeit that is impeding sales of new debt arguably violates the spirit of this rule.

The fact that Trichet had denied that the ECB governing council had even discussed government bond purchases when questioned about this at the press conference following their monetary policy meeting on the Thursday preceding the EU finance ministers' weekend summit gives the impression that the ECB was influenced by the inter-governmental negotiation. Given that these discussions were apparently fraught, with French President Sarkozy reportedly threatening to withdraw France from EMU if an agreement including a sceptical Germany represented by Chancellor Merkel could not be reached, it is not hard to imagine that the ECB was pressurised to support the package.

The retreat by the ECB is particularly disappointing because it represents a missed opportunity for Europe to interrupt the sequence of bailouts that have characterised the financial crisis since the demise of Lehman Brothers in September 2008 and to differentiate the euro as a reliably hard currency even in adverse circumstances.

Allowing at least Greece to be driven to default or restructure its government debt – assuming that Greece could not adjust its finances to service that debt – before compromising the ECB's standards would have established the principle that, in the eurozone, an individual state can run out of money like a corporation, and that the risk premium on debt should be regarded as advance compensation for genuine risk of default. With Greece's reputation for misreporting economics statistics, tax evasion and generous public sector remuneration, there was relatively little support in the rest of the eurozone for a bailout of Greece, and given the size of the fiscal adjustment that Greece must make to avoid default even with the support of its €110bn conditional loan facility, Greece may yet default anyway. It would have been better for the EU to draw the line before, say, Portugal rather than Greece.

Many commentators claim that the eurozone authorities' real reason to bail out Greece was that so much Greek debt was held by eurozone banks that even restructuring was likely to impose sufficiently large losses to bankrupt those banks and reduce Europe's banking capacity enough to cripple its economy. If so, this was an unwise decision. First, bailing out a country means saving all its creditors, making it an inefficient way to protect banks. Second, unless banks are formally bankrupted, it is difficult to make full use of their shareholders' and junior creditors' money to absorb losses, making bank failure more costly for the taxpayer. And in Europe especially, bankrupting a bank need not involve disruptive closure and complete liquidation; it is easier to nationalise a failing bank in Europe compared with America where the public are more hostile to state ownership. As it is, the danger is that bank losses on sovereign debt are offloaded to the eurozone states, increasing their indebtedness and intensifying the pressure on the ECB for further accommodation. Ironically, in making concessions to abet the eurozone bailout of Greece to avoid a mythical banking meltdown, the ECB may find that it has opened a Pandora's Box.