At least so far, it appears ECB intervention has been successful in significantly lowering Italian and Spanish bond yields.
Paul Krugman has a nice little post using the idea of multiple equilibria to explain how such interventions might work, even with what could actually be relatively modest bond buying.
If your appetite for multiple equilibria models is whetted, here is a fascinating paper by Paul in which he explains the self-fulfilling crisis logic in much greater detail, though it is in the context of a currency rather than a debt crisis. The comments at the end by Kehoe and Obstfeld are also well worth reading. Interestingly, Paul is quite circumspect in the paper about the quantitative importance of multiple equilibria, putting more emphasis on steady deterioration in the fundamentals.
33 replies on “Paul Krugman on Multiple Equilibria”
I hope the ECB is not deterred by the fact that Krugman thinks they are finally doing something right. I’m reinforced in my view that Ireland’s best chance is for Italy and Spain to join us in the doghouse. That way the EU has to pay attention.
Interesting piece here by Dave Goldman
Not sure how it links in with Dr Nobel….
There is no possible bail-out of Spain or Italy ,there are just too big.If they default it is the end of the Euro,and the first victims would be Ireland and Greece.
Why waste time on such irrelevant twaddle?
Desperate times need desperate measures, not the meanderings of theoretical economists.
–John Maynard Keynes (1883-1946) in The General Theory of Employment, Interest and Money
Otmar Issing tells us – once again – how the euro was all a big mistake.
“Almost all treaties promising European fiscal discipline have been broken time and again. The worst example was delivered by France and Germany in 2002-03, when they violated the Stability and Growth Pact, and even organised a political majority against the application of its rules”.
The FT says;
“That makes it all the more important for the new economic governance regime to control the right things: growth must be given as much attention as fiscal rectitude, private balances as much as public ones, and sanctions must be automatic, not depend on the say-so of the big nations. The old stability and growth pact lacked all of these elements. That is why it failed”.
The two countries blocking the necessary introduction of automatic sanctions – you guessed it – are Germany and France.
Having one’s cake and eating it is a difficult exercise, whether for Otmar Issing or Germany.
I suppose you have some reason for thinking Ireland would be a “victim” of the end of the Euro. For my part I don’t think it will matter all that much, if indeed it happens. There will be quite a bit of disruption of course, as there was with the breakup of the Bretton Woods system in the early 1970s and the severance of the link with sterling a few years later. But monetary arrangements come and go. When the dust settles a healthy, educated population invariably manages to build a healthy economy using whatever coinage happens to be in circulation.
DOCM: “Why waste time on such irrelevant twaddle?”
To the barricades! I’ll be right with you, DOCM — as soon as this pub closes.
@ John McHale
Indeed! Not having read many economists, defunct or otherwise, I will continue to consider myself a practical man. It is for others to judge whether this exercise in self assessment is correct or not.
PS: If I’d known that the song was on YouTube I’d have added a link for the benefit of younger readers:
“But monetary arrangements come and go. When the dust settles a healthy, educated population invariably manages to build a healthy economy using whatever coinage happens to be in circulation.”
I certainly agree with that,the question is :in what time frame?
To quote Keynes again :”In the long term we are all dead”.
@ John McHale
Considering this post from K-dude:
“The Downgrade Doom Loop
It’s not the whole story, but something like this threatens to develop:
1. US debt is downgraded, sparking demands for more ill-advised fiscal austerity
2. Fears that this austerity will depress the economy send stocks down
3. Politicians and pundits declare that worries about US solvency are the culprit, even though interest rates have actually plunged
4. This leads to calls for even more ill-advised austerity, which sends us back to #2
Behold the power of a stupid narrative, which seems impervious to evidence.”
…..it is surprising he hasn’t spotted that:
a) the S&P (yes THAT S&P! ) 500 index bottomed intraday at 666 in 2009.
b) today it closed down 6.66%.
and, while we are at it, has anybody actually ever seen the K-crusader’s reflection?
Picking up on a post by Mr Bond
“European Central Bank mounts rescue for Italy and Spain – but sets its price”
“But the latest move appears to have involved the ECB in far more than buying bonds. According to the Italian daily, Corriere della Sera, the bank’s president, Jean-Claude Trichet, and his successor-designate, the governor of the Bank of Italy, Mario Draghi, sent a letter to Italy’s prime minister, Silvio Berlusconi, at the end of last week dictating the terms on which the ECB was prepared to buy Italy’s increasingly costly debt.”
Trichat vs Krugman round 2.
I am confused by Krugman’s argument. It may be because I don’t understand the bond market. Maybe someone can help me with this?
As I understand it, there are two bond markets. The initial bond auction, and then the secondary bond market. I had thought that changes in the yield in the secondary market would have no direct impact on Italy’s debt obligations. That is, that the actual amount of money that Italy has to pay out would be unaffected.
My understanding was that activity in the secondary market matters to the Italian government only in the following way. The yield we see in the secondary market is indicative of the yield Italy would probably have to offer at its next auction.
But Krugman’s argument seems to imply that by reducing the yield in the secondary market, the ECB actually reduces the burden Italy is under. That it reduces Italy’s likelihood of default. I don’t see how this can be?
Certainly ditching the Euro means a lot of disruption. I wouldn’t decree its abolition if I had the power. But if it can’t cope with a bear market in the bonds of the bigger countries then it’s doomed in any case. Either it gets modifications which make it seaworthy or it sinks. From Ireland’s point of view, either outcome is better than one where we are locked in a flooded compartment with Greece and Portugal while the band plays on in the ballroom.
Tunafish, you said it yourself: “The yield we see in the secondary market is indicative of the yield Italy would probably have to offer at its next auction.”
The gloom in the secondary market can be self-fulfilling. It’s just like the case of a bank which actually has sound assets, but whose depositors succumb to panic. In that situation it makes sense to take out your cash, even though you don’t think the panic is justified.
@ Kevin Donoghue
Exactly! As Winkler has pointed out, governments are now so indebted that they need to continuously roll over their debts and have become involved in what he describes, in a manner that is illuminating for me at least, as a practical man, as “maturity transformation” i.e. they have effectively become banks and are prone to all that ails such institutions, especially in a monetary union where they cannot pay off their debts in a debased currency.
Their only salvation is to band together and issue paper of some kind which restores confidence, the exercise on which the members of the EZ are presently embarked, by giving the necessary guarantees to enable the ECB to intervene while they try to get their act together on the reformed EFSF.
There is need neither for a fiscal nor a political union; simply a mechanism which restores confidence – at a cost to all – while confidence is restored in them individually. This requires them to balance their public accounts and the ones that do it quickest will get out of the morass quickest. How they do it is a matter in which they may retain the necessary sovereignty. This brings us full circle back to the Stability and Growth Pact which, incidentally, binds all the members of the EU and not just those of the Euro Area. The UK is clearly on board (at least under the present government). Why not France and Germany?
You make a valid point. The self-fulfilling panic argument is strongest when the debt is short-term, and has to be rolled over quickly. As Kevin says, the yields on the secondary market then indicate what the cost of new debt will be. Expectations of high default risk forces high interest rates, potentially validating the initial expectations. The chances of falling quickly into a bad equilibrium are certainly lessened if the debt has a long average maturity, but the risk of self-fulfilling crisis does not disappear. As best I can recall, the average maturity of Italy’s debt is about seven years, so the average interest rate on outstanding debt will rise relatively slowly. However, as we have seen in our own case, the cost of new borrowing can rise quite quickly, even as the average interest rate rises slowly, and you can still be quickly forced out of the market.
I’m curious, what is the ‘true’ risk-premium for holding on to Italian bonds?
I’d say that whoever decides the ‘true’ risk premium (when the buying will end) at the ECB has a very, very high opinion on his/her ability to price sovereign risk.
Central planning of that kind would work in an ideal world, however, as we’re living in the real world, it won’t 😉
The faith in the ECB being infallible seem almost religious….. The ECB is good, but it is not that good -> End the bailout of failed investors and stop the bond-buying programme.
I seem to recall reading a paper that pointed out that bond markets would ‘punish’ sovereigns for high inflation by keeping bond prices elevated for longer than the inflation lasted – while they might lag initially, eventually with new issuance/rollover they catch up and interest rates contain a risk premium.
If this is the case and it is also true that “governments don’t repay sovereign debt” then higher inflation, unless it is very high, is another method of borrowing from future prosperity to pay for past mistakes – another badly aimed kick at the “concrete can of the present” aimed firmly at the “somebody else’s problem of the future”.
Like others, I’ll stick to my line that high inflation hurts those with least far more than it hurts those with most. Default and deflation on the other hand…
“I’d say that whoever decides the ‘true’ risk premium (when the buying will end) at the ECB has a very, very high opinion on his/her ability to price sovereign risk. ”
Not just that, but also to price inflation expectations. The end-game for the ECB is that they are buying all sovereigns in the eurozone, as the Fed were buying in the US. Inflation expectations would then become unanchored to the downside as the indicator mechanism that the bond market provides is suppressed.
Secondary market purchases by a central bank may also be used in a more direct way to encourage investors to rollover debt. The purchases are often timed to be either just before and/or just after a primary market auction. This allows an investor to sell an existing bond, to the ECB say, and then buy a newly issued bond. After this the investor has the same net exposure and the ECB has increased exposure. Also the ECB may allow an investor to “flip” a bond, i.e. the investor buys a new bond and sell it immediately to the ECB. Again the investor’s exposure before and after is the same, but the ECB has increased exposure.
That’s the theory anyway. I’ve no knowledge of how these things work in practice, and the degree of collusion, or otherwise, needed to organize this.
The Emperor has no clothes…
“Now for the hard part. Unless the ECB is willing to back up its new role as lender-of-last-resort with massive purchases of Italian and Spanish debt, it will inevitably be tested by markets. Weak hands will take advantage of rallies to offload holdings onto the ECB, i.e. onto eurozone taxpayers. Frankfurt will find itself underwater very quickly without a legal mandate or EU treaty authority.
RBS calculates that the ECB will have to buy roughly half the outstanding tradeable debt of the two countries to defend the line. RBS calculates €850bn. I would put it nearer €1 trillion.
This is currently impossible. The ECB is acting as a temporary back-stop until the revamped EFSF bail-out fund is ratified by all parliaments over coming months. The EFSF will then take the baton.
Yet as we all know, the EFSF has no money. The parliaments have not even ratified the earlier boost to €440bn. As of today, the fund has barely €80bn left after all the commitments to Greece, Ireland, and Portugal. It remains a fiction.”
Ambrose reckons the latest effort could last all of three weeks…
Ambrose is being optimistic. At 5 bn a day, the ECB would rack up 45 bn in three weeks. I can’t see it myself.
Zerohedge have a chart that shows why the ECB effort is doomed. You can see why the ECB would be looking for an indemnity against losses. And why private investors, without a guarantee, and de facto junior to official creditors, will not be knocking themselves over in the rush to buy new Italian/Spanish bonds. The whole scheme a great way for private investors to exit and then just walk away.
Also within 24 hours of a G7 statement promising cooperation, coordination etc. we have Geithner saying the EFSF must be bigger and Merkel saying it must not get bigger…
“The whole scheme a great way for private investors to exit and then just walk away.”
Been harping on about this. It is the perfect exit mechanism for the banks and who would want to buy Italian bonds. As for the Spanish bonds, these are as bad if not worse with the potential property losses unrecognized. You only have to look at what happened when we admitted the scale of the problem and Spain has a similar property situation to that of Ireland.
1 to 2 trillion of cash production should do it, or at least make a good start.
Thats if they want private credit to be paid – otherwise the payments mechanism starts to break down with even more inefficiency in the economy.
The Base must be doubled.
The calculation is that you can guesstimate a yield that over quite a long time would make Italy’s debt unsustainable. If 10 yr goes higher than that, you have to take a view, is it a blip caused by irrational panic, or should you – as the term structure implies – assume yields are likely to remain that high or thereabouts?
If the latter then you know that as bonds are rolled into new, expensive funding, Italy heads for default / bailout / hinterland of Germany or whatever – and you have a rationale for selling, but not for buying – hence spiral. If you don’t sell, what should you tell the fund trustees?
The ECB buying gives the first scenario – blip – the potential to gain traction.
It gets worse – the joint German-French statement also didn’t last 24 hours:
And to add to that
New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. “It should reduce rates to zero, and make big purchases of government bonds,” he said.
Frankfurt is unlikely to heed the advice. The bank’s president Jean-Claude Trichet, last week stuck to his anti-inflation script and said “we do not do QE”.
It’s looking like The Banker who broke the World all over again
Thanks very much to Kevin, John, Bryan and Grumpy for the help!
@ Bryan G, Hogan, Ceteris, Mr Bond, etc
Just trying to keep up. I see the reports and comments above about ECB buying in the secondary sovereing bond markets for Spain and Italy, but I don’t see at what prices the bonds are being bought. Is it by implication (or explicitly) at current market value or is there something else going on?
Kevin Donoghue Says:
“I suppose you have some reason for thinking Ireland would be a “victim” of the end of the Euro. For my part I don’t think it will matter all that much, if indeed it happens. There will be quite a bit of disruption of course, as there was with the breakup of the Bretton Woods system in the early 1970s and the severance of the link with sterling a few years later. But monetary arrangements come and go. When the dust settles a healthy, educated population invariably manages to build a healthy economy using whatever coinage happens to be in circulation”
(speaking as an American, who’s been casually observing things Over There, frequently thorugh this blog)
I would ordinarily agree that ‘when the dust settles’ can mean a long, nasty, rough time, and reject this.
But from what I can gather, the situation for Ireland is that they are paying any bailout money from the ECB to the UK/French/German banks, with Ireland just endorsing the checks over. Therefore the ECB bailout is just subsidizing the big Eurobanks, with Ireland not receiving anything for it.
Which causes problems because the terms of the bailout are crushing the Irish economy, resulting in a strong negative effect. By now, I think that this is deliberate. The core of Europe is going to economically destroy the periphery, so that the big Eurobanks get paid off. A negative sum game for Europe as a whole.
At that point default makes sense, because there’s no chance at all of paying off the loans, and the bailout is negative for Ireland. That leaves the choice between doing it soon, or postponing the inevitable, while being bled dry in the interim.