LBS: Monetary and financial stability in the euro area Post author By Philip Lane Post date May 10, 2011 Lorenzo Bini Smaghi argues that markets can mis-price sovereign default risk in this speech. Categories In Uncategorized 33 Comments on LBS: Monetary and financial stability in the euro area ← Men Without Work → Bank Credit Flows and Eurozone Stability: Conference Panel QA Session 33 replies on “LBS: Monetary and financial stability in the euro area” 😕 Is Mr. Bini-Smaghi arguing with his Christopher Columbus example against the single currency? And the EU itself? What haircut does the ECB apply to sovereign bonds? That sets the base of their market value… Lorenzo says: “At times markets have perverse incentives. In particular, large investors who have bought insurance against sovereign default, often without holding the underlying asset, stand to benefit greatly from the default and lobby in favour of it. ” JTO again: There is no difference between what Lorenzo is saying here and what I posted in the Morgan Kelly thread yesterday? He’s just saying it a little more diplomatically. @ JtO “At times markets have perverse incentives. In particular, large investors who have bought insurance against sovereign default, often without holding the underlying asset, stand to benefit greatly from the default and lobby in favour of it. ” Yes, and this should be banned. Three reasons not to make explicit what happens when countries seek to restructure debt or default, with suggested solutions: “First, as over 50 years of IMF experience have proven, market assessments of the solvency of countries tend to be wrong. In the vast majority of cases, sovereign risk is overestimated or underestimated over a long period. This is because sovereign risk does not depend only on debt sustainability, but also on the political will to implement adjustment programmes, including privatisations and structural reforms.” Solution: Independent ratings agencies to end conflict of interest. Do it better. “Second, at times markets have perverse incentives. In particular, large investors who have bought insurance against sovereign default, often without holding the underlying asset, stand to benefit greatly from the default and lobby in favour of it. They tend to encourage naïve governments to believe that debt restructuring can be done in an “orderly way”, distracting them from implementing the appropriate policy adjustment.” Ban this activity. I paraphrase, but why should know arsonists be allowed to take out insurance on houses they don’t own. “Third, default or debt restructuring is a dramatic economic and social event for the country which experiences it – I would call it political “suicide” – which leads many into poverty, as experience has shown. It is thus rather peculiar for policy-makers to design policies mainly with the aim of punishing (or rewarding) certain categories of investors, rather than considering the ultimate consequences for the people.” Compare Ireland and Iceland. Are they really so polar? Solution: Better research of process and outcomes required. Surprisingly interesting speech – I get the feeling we are going to enter a massive change of tempo in the markets. The phoney war may be at a end. He wants the Euro to remain in the center of the vortice me thinks. I know I have only a one track mind when it comes to this but I think they are close to hitting the red button. He makes some good points further down in the paper. It’s a pity about the large early section where he conflates adopting, perhaps even sharing, innovation from abroad and resource grabbing with what is still called “free trade” by comparative equals, and not just that but he conflates free trade or “competition” between comparative equals – parties of similar annual per capita income and industrial- -technological, scientific and political development, hundreds of years ago – with the near ruin of much of the old G7 in the last decade or so through rapid liberalisation of what is called “trade” between developed parties and huge rather feudal (village) populations of near zero annual per capita income who are readily disposed to work on assembly lines for little more than a bag of rice per month – a month being approx. eighteen hours per day, seven days per week and eleven and a half of them per year. “There is probably no historical precedent for the speed at which these changes are taking place.”: Indeed! Id like to see what he has in his bank accounts, his retirement account, his wallet, behind the cushions in his sofa and so on. After all, hes clearly speaking from a position of influence and he must therefore be suspect. Good lord, next thing will be some “journalist” speaking eh JtO? The speech struck me as fairly empty but very high-minded in tone, with boring references to Jared Diamond’s discredited “longitudinal” theory of European development. Now that day-to-day events in the Eurozone are getting really interesting, Bini Smaghi wants to rise above the fray and gaze at the broader historical narrative. Quoting various world philosophers and the long sweep of history he seems a bit out of his league as a central bank board member. Agh – its moral hazard man! he’s like a toxic banker sent back from the future to sow the seeds of the next bailout – i wonder if he is actually an atm machine under his skin – actually he’s constructed entirely of compressed hot air @Gregory, Perhaps this is his equivalent of Alan Greenspan’s ‘weightless economy’ speech when he was required to say something but didn’t wish to say anything that move the markets. However, by mentioning the frequent, perceived irrationality of, mis-pricing of risk by and perverse incentives of financial markets he is hinting at the over-riding EU strategic objective of bringing the forces of financial capitalism to heel. And along the way, he implicitly exhorts the peripherals to ignore high yields in trading in thin secondary sovereign bonds markets and to stick with the programme. But he fails to mention that, in its attempt to secure political support to make the changes that will be required to achieve the strategic objective of bringing financial capitalism to heel, the smaller peripherals have been placed beyond the fire-break – or that serious efforts will be made only when the outcomes of the 2012 French Presidential and 2013 German Bundestag elections have been digested. Everything is being geared to remain in can-kicking mode until then. This man should take his quack version of human history, together with his quack economics and take up residence on the Galapagos island, where he could continue to contemplate human development and try some economic experimentation. It is thus rather peculiar for policy-makers to design policies mainly with the aim of punishing (or rewarding) certain categories of investors, rather than considering the ultimate consequences for the people. The above quote from a board member of the ECB which has insisted, on pain of economic war, that certain catagories of investors be reimbursed for their losses out of the pockets of people who had no hand act or part thier investments. Opinions differed within the Union. Some were tempted to leave the countries to their fate, to pay for the mistakes they had made. But others were prepared to help – even unconditionally – thinking that in future they might benefit from the same assistance if needed. Should all the citizens of all former fascist countries have paid “for the mistakes they made” with their necks as those at Nuremburg did? Perhaps this uber-quack historian/economist would reflect on that. Perhaps we all should reflect on it. Ireland would now be far far better off if it had never heard of the ECB. The ECB and Bini Smaghi in particular should butt out Irish affairs. They have gone a long way-along with Ahern, McCreeby, Harney and Cowen- to destroying a decent people. @Joseph, Perhaps if you might reflect a little, you will find that your comment is somewhat unnecessary and extreme. This is more of the same from LBS and his problems and solutions strike me as a lazy re-hashing of old rhetoric. “First, as over 50 years of IMF experience have proven, market assessments of the solvency of countries tend to be wrong. In the vast majority of cases, sovereign risk is overestimated or underestimated over a long period. This is because sovereign risk does not depend only on debt sustainability, but also on the political will to implement adjustment programmes, including privatisations and structural reforms.” – It is certainly true that the markets can under or over estimate risk, but LBS’ implication appears to be that the ECB and/or politicians are is in a better position to judge the solvency of countries and act accordingly. I believe it’s also fair to state that 50 years of IMF experience have proven that politicians and technocrats have an even poorer record of calculating sovereign risk than the market (otherwise there wouldn’t have been a single default). [@ Gavin Kostick – I think that the roles of independent rating agencies in the US housing bubble and allowing excessive leverage to build up in peripheral Europe, via their optimistic ratings has disproved the idea that they can do anything ‘better’] “Second, at times markets have perverse incentives. In particular, large investors who have bought insurance against sovereign default, often without holding the underlying asset, stand to benefit greatly from the default and lobby in favour of it. They tend to encourage naïve governments to believe that debt restructuring can be done in an “orderly way”, distracting them from implementing the appropriate policy adjustment.” – Now a hint that shadowy svengali figures are behind whispering in the ears of politicians and trying to lure them away from the path of righteousness. At least he’s changed the record slightly, now that it has been proved repeatedly that the outstanding CDS volume is tiny and it has had little or no impact on the crisis (see here http://www.efinancialnews.com/story/2011-03-21/cds-sector-laments-crackdown and here http://cib.natixis.com/flushdoc.aspx?id=53358 ). He is now shifting away from the process and toward some unknown and presumable wealthy individuals (we hate the wealthiest ones the most). Who exactly are we talking about? What governments are they speaking to? Where exactly is the evidence for this? My guess is they’ll never be found, because there is no conspiracy. As David Einhorn, who was one of the first to recognize Lehman as a ponzi scheme, observed – I’m not critical because I’m short, I’m short because I‘m critical. Perhaps the ECB should listen to what the shorts are saying rather than branding them outlaws. “Third, default or debt restructuring is a dramatic economic and social event for the country which experiences it – I would call it political “suicide” – which leads many into poverty, as experience has shown. It is thus rather peculiar for policy-makers to design policies mainly with the aim of punishing (or rewarding) certain categories of investors, rather than considering the ultimate consequences for the people.” – I’m not aware of any policy makers whose main aim is design policies to punish or reward investors. Any punishing would be a second-order effect caused by policy makers who believe that the effect on the people of a short-term restructuring would be less than a long-winded deleveraging. The consequences might be worse for the people in the end, but I don’t believe the main aim for policy makers would be to ‘burn the bondholders for a laugh’. As for his solutions, he needn’t have bothered repeating the same tired ECB mantra – the simple solution to all of the peripheries problems is more austerity, more structural reform and more supervision. I hope this article is his swansong, as the press rumors appear to indicate. http://www.bloomberg.com/news/2011-05-01/ecb-s-new-blood-may-spell-faster-rate-increases-as-draghi-eyes-presidency.html @ Paul Hunt Unnecessary and extreme perhaps, but it is hard for the blood not to boil at the praise for Columbus and the conquistedores, with no mention for the consequences for the people and civilizations of North and South America. Was the wealth and gold bullion, made from the melted down artifacts, and the bones of dead slaves really the right thing to celebrate? Was this Europe’s finest hour? Perhaps you are wise Paul, to consider the meaning and underlying context, but Bini Smaghi makes it tough. As for this bit: “Opinions differed within the Union. Some were tempted to leave the countries to their fate, to pay for the mistakes they had made. But others were prepared to help – even unconditionally – thinking that in future they might benefit from the same assistance if needed.” I think it’s simply a misprint and should read: “Opinions differed within the Union. Some were tempted to leave the banks to their fate, to pay for the mistakes they had made. But others were prepared to help – even unconditionally – thinking that in future they might benefit from the same assistance if needed.” @Paul Hunt/Others I do accept, having cooled down a little following reading the Bini Smaghi article, that some of my remarks were extreme. As such, with the indulgence of the readers, I would like to take back the following paragraph: Should all the citizens of all former fascist countries have paid “for the mistakes they made” with their necks as those at Nuremburg did? Perhaps this uber-quack historian/economist would reflect on that. Perhaps we all should reflect on it. The rest remains. I have no time for Bini Smaghi, his version of history or his economics. @Joseph, Thank you. I have no wish to come across as all po-faced and priggish, but Dr. Bini Smaghi provides more than enough material for cold, clinical demolition. I can understand why blood might boil when confronted by his insouciance (which I expect is shared by many of the EU’s Grand Panjandrums) about the malign real-life implication of holding the smaller peripherals’ feet to the fire to buy the political and institutional EU the time to mantain its stately progress in line with the political cycles in France and Germany as it slowly, ever so slowly, gets to grips with the major chellenges it faces. It doesn’t matter what structural reforms the peripherals can implement – or to what extent these are in their interests. And it doesn’t matter what amount of funding support or extraordinary bank liquidity support is provided. While voters in these countries perceive they are being bled to allow the EU’s Grand Panjandrums to proceed in their leisurely manner and to postpone confronting the political and institutional challenges, political anger and opposition will grow – and grow potentially to dangerous levels. The right and centre-right governments, particularly in France and Germany, are almost paralysed by the fear that, were they to confront thier voters with the reality of what is required to repair the damage wrought by the dalliance of some of their banks and financial instutions with (and sometimes as the patsies of) the international banking and shadow banking system, their fury would cause a politcial upheaval of seismic proportions. The anger that already exists is being channelled by largely populist, nationalistic, xenophobic forces. The threat of ungovernability is real. Belgium is coming up to being a year without a govenrment. A minority Dutch government has Gert Wilders’s Freedom Party in support outside of government. The Danish government is similar configured. And something similar is likely to emerge in Finland. The Swedish Democrats deprived the outgoing right-centre government of an overall majority. Marine le Pen’s NF is on the March in France and the political mood in Germant seems sour and febrile. The usual, cowardly and tactical political approach is Micawberish – something will turn up. Let’s keep our heads down and it might all blow over. This is more than stupid. It is downright dangerous and irresponsible. But we have no leverage in this arena, except continuous quiet, but firm, words from the government. And threatening anything unilateral is likley to be extremely counter-productive. We need to move on from this denial about our almost total loss of sovereignty. This was lost in Sep. 2008 – not Nov. 2010. The buyer of a cds pushes the price of risk up, a seller pushes it down. A seller, sort or covered, of bank shares or bonds, pushes the price of risk up. Lozza BS points out damage can be done by market mispricing. Where is the evidence that more damage has been done by the overpricing of risk rather than by its underpricing. Why are people who think financial risk is underpriced assumed to be evil and corrupt, but those who think risk is overpriced assumed to be wise and upstanding defenders of Europe? @Paul Hunt “The anger that already exists is being channelled by largely populist, nationalistic, xenophobic forces.” The True Finns have been painted as such but reading the article by Timo Soini in yesterdays WSJ I think he is telling it as it is…. “It is not the little guy that benefits. He is being milked and lied to in order to keep the insolvent system running. He is paid less and taxed more to provide the money needed to keep this Ponzi scheme going. Meanwhile, a kind of deadly symbiosis has developed between politicians and banks: Our political leaders borrow ever more money to pay off the banks, which return the favor by lending ever-more money back to our governments, keeping the scheme afloat. ” “Instead of accepting losses on unsound investments—which would have led to the probable collapse and national bailout of some banks—it was decided to transfer the losses to taxpayers via loans, guarantees and opaque constructs such as the European Financial Stability Fund, Ireland’s NAMA and a lineup of special-purpose vehicles that make Enron look simple. Some politicians understood this; others just panicked and did as they were told.” This is not just about economics. People feel betrayed. In Ireland, the incoming parties to the new government promised to hold senior bondholders responsible, but under pressure, they succumbed, leaving their voters with a sense of democratic disenfranchisement. The elites in Brussels have said that Finland must honor its commitments to its European partners, but Brussels is silent on whether national politicians should honor their commitments to their own voters. In a democracy, where we govern under the consent of the people, power is on loan. We do what we promise, even if it costs a dinner in Brussels, a “negative” media profile, or a seat in the cabinet.” And our lot today announce confiscation of part of everyone’s private pension scheme. Once you establish that it is legitimate to take some of these funds then the stage is set for more and other asset confiscation. Timo has it right. @Dear Lorenzo One avenue that has been advocated by some is to make more explicit the conditions under which countries, like companies, would not repay their obligations and would restructure their debts or even default. The proponents argue that such explicit rules would improve the ability of markets to price sovereign risk and, thus, to exert discipline on governments with a view to achieving sounder fiscal policies. This view is predicated on the general principle that investors should bear the consequences of their decisions. Although at first sight this may seem reasonable and fair, it is wrong not only in theory but also in practice.” Huh! No Comment! I leave to future postmodernists researching the discourse of Frankfurt’s Great Inaction in seeking some logical arguments. “[Lorenzo; the Florentine self-portrait] … young, vigorous but also gentle, his gaze fixed fearlessly on the challenge; he can triumph, against all odds. That’s the way Europeans should be.” Spose he’e prefer a golden bust by Cellini to his upcoming gold watch! He can wait ….! @Paul Hunt JHC Paul! You’re becoming so dismal now you deserve an honourary MA Econ. from UCD; John TheOptimist is also on the roll call. More on Currency Rise of the Rupee, Real and Renminbi Rival Currencies Take Aim at Dollar’s Dominance By Christian Reiermann http://www.spiegel.de/international/business/0,1518,761398,00.html#ref=nlint …finally, newz from Berlin ….. on ECB LB-S; interesting parallels … The center-right daily Frankfurter Allgemeine Zeitung writes: “Today, exactly one year after Greece received an aid package worth €110 billion, it has become apparent that the rescue has failed and the country will not be able to get back onto its feet without restructuring its debt. As willing as the EU was to put together a new aid package, it is now ruling out a Greek default because, it is said, banks would begin to fall like dominoes. But the banks have long since transferred their problematic Greek debt holdings to the European Central Bank, which willingly took it on. The ECB has become Greece’s largest creditor. Given the sums involved, one could almost say that the entire Greek banking system belongs to the ECB. Greek banks have refinanced themselves via the central bank to the tune of €91 billion. In addition, the ECB is thought to have bought up Greek state bonds worth €47 billion. A restructuring of Greek debt would be a catastrophe for the European Central Bank.” http://www.spiegel.de/international/europe/0,1518,761723,00.html#ref=nlint @DOD Wonder if the Greek Central Bank are also financing their banks like our own CB. It would be interesting to see all the numbers. Little wonder the ECB is so opposed to restructuring with insolvency staring them in the face. @ceteris paribus ECB probably is insolvent! If real! Is it? Interesting parallel with Morgan Kelly’s suggestion on ownership of failed banking systems – if so, insolvency it is. Will truly spoil poor ol’ Lorenzo’s CV – spose he’s hoping to get out in time. @ceteris “And our lot today announce confiscation of part of everyone’s private pension scheme.” At least we now have a wealth tax, even if it hits everybody. For some inexplicable reason Lorenzo’s speech writing has taken me back to thee most famous of all BBCs dramas I am half way through this most enjoyable of marathons http://www.youtube.com/watch?v=B9PA_DB9K04 Its worth the distance. Hail future Caesar The ECBs book being stuffed full of bonds that might be defaulted on makes the institution incapable of objective reasoning on this . Hence increasingly bizarre and detached from reality pronouncements from Lozza BS and Co – banning default by declaring it cannot happen for example. These bureaucrats are not comfortable with a situation in which they have de-risked the entire EZ banking system and have not been told by those that appoint them that their arses are covered if they are revealed to have vastly overpaid for assets and require recapitalisation. They think they have been stiffed and are determined not to have to take the rap. @grumpy “Why are people who think financial risk is underpriced assumed to be evil and corrupt?” Not so much that the traders in CDS are evil but the CDS concept itself in it’s existing form where there is virtually no regulation is dangerous and “evil” if you like. Why is it legal to be allowed to purchase insurance on an asset which you don’t own. The analogy of insurance companies selling fire insurance on one’s house to arsonists is pretty well known by now but the case against it is unarguable. It’s sheer insanity and the misunderstnading of their lethal nature was central to the subprime bubble and burst of which the AIG collapse and bailout was the most spectacular example. @ Edward v2.0 Thanks for the post. I might have been better to keep mine to a simple, ‘these three reasons looks specious.’ @AmMcGrath. I agree. @Gavin Sorry I hadn’t read your earlier post – we are making the same point of course. I think CDS are “underdebated” on this site. The case for banning at least the naked variety seems overwhelming. @Grumpy “banning default by declaring it cannot happen” there is a children’s story about this type of behaviour . Something about an emperor. @ AmcGrath, Why is it legal to sell Insurance on an asset you don’t own? Why is it legal to gamble? Isn’t it like if p happens I get x, if 1-p happens I pay y @Carawaystick “Why is it legal to gamble?” Are you suggesting that the Insurance industry should be allowed to sell insurance on your/my house to every Tom, Dick, and Arsonist. There are good reasons why the Insurance industry is regulated. “Isn’t it like if p happens I get x, if 1-p happens I pay y” Of course if I can arrange to ensure p happens then the dice is weighted. Not saying they’re all at it but if you are that way inclined what is to stop you? Even gambling is fairly strictly controlled especially in the US. Naked CDS are just a charter for fraudsters and if they are too complicated for those in the game to understand, i.e AIG, then what hope for the rest of us. If you really want to gamble go to a Casino. Comments are closed.