Gavyn Davies: Does the ECB really have a silver bullet?

Gavyn Davies has a useful piece in today’s FT highlighting the potential inter-country distributional consequences of ECB actions in support of particular countries (see here).   These consequences are critical to understanding the economics and politics of ECB interventions.   A few key paragraphs:

The implication of this analysis is that the ECB has more than enough “capital” to underwrite the peripheral bond markets, without this being inflationary in the long run. In a single nation state, it would probably prove irresistible to bring forward some of this capital from the future into the present, and then use it to purchase government bonds to resolve the crisis. In countries like the US and the UK, the national treasury could, in extremis, simply command the central bank to do this, which is why independent nation states typically cannot be forced to default on their domestic currency debt (although they might choose to do so by inflation).

The situation of the ECB is different for the now-familiar reason that the institution is the central bank of many nation states, which care very much about the distribution of income and wealth between themselves. The use of the central bank’s non-inflationary capital does not get round this fundamental issue. Since the ECB is owned by all of its members in proportion to their share of eurozone GDP, the future seigniorage of the ECB is similarly owned by all of its members.

If the ECB board chooses to use its notional capital today by buying Italian bonds at subsidised rates, it is in effect triggering a transfer of resources to Italy, away from other members, most notably Germany. This could emerge in the form of ECB losses which might need to be to be recapitalised by member states after an Italian default. Or it might emerge as a reduced flow of future profits from the ECB to nations like Germany. In any event, there would be an implied transfer of resources from Germany to Italy, which is precisely what the German government has opposed implacably.

18 replies on “Gavyn Davies: Does the ECB really have a silver bullet?”

Nigel Reed makes a good point in the comments: “If the ECB created new money and distributed it to the eurozone countries according to their share capital, so there would be no transfer between states, Italy could use it to reduce debt to manageable levels and Germany could use it for reflationary purposes, thus helping to stimulate demand in the eurozone.” If the distribution of seignorage was the real issue, we’d have cracked the problem by now. The really big problem is that the people who run the ECB are far too remote from the one-in-five members of the Spanish labour force who are jobless.

Actually this is as good a place as any to say that I think the really big question of our times is: who was right, Keynes or Kalecki? Roughly speaking, Keynes said that the only reason that governments don’t adopt the expansionary policies needed to get us out of a slump is because politicians are slaves to defunct classical doctrines; Kalecki said those policies don’t get adopted because it simply doesn’t suit the powerful to acknowledge that such measures can work. Lately my impression is that Kalecki has the better of the argument.

@Kevin Donoghue
I think Mr. Keynes, Mr. Kalechi and your good self vastly overestimate the knowledge and capability of politicians. Few, if any, have ‘doctrines’. Some might have half-baked ideas, but there are rarely any who will not spend if they can.

Let’s face it, we’ve had ten years of stimulus in many countries. Tax receipts as a percentage of GDP in Keynes’ time were half what they are now – of course he saw scope for deficit spending. Savings rates were higher, the welfare state didn’t exist, national debt was lower.

The wealth of generations has been spent in a splurge of conspicuous consumption and I don’t just mean in Ireland.

@ John McHale

Gavyn Davies is correct in his assessment. But accepting that fact does not mean that the countries of the richest corner of the globe have suddenly turned into a bad risk. They simply lack the means to make this fact operational in the markets. The idea of “safe bonds” is one possible solution.

I am not an economist but the political mechanics of the situation are understandable by anyone devoting a little time to the subject. cf. the paper by Winkler to which I have linked by now on quite a number of occasions and post now a PowerPoint presentation.

On another thread, the proposal from Merkel’s own Council of Economic Advisers is being discussed and the essential point being largely missed. It is a political one and could not be clearer. The German political class is attempting to abscond from its responsibilities for the euro, having accepted its creation, and benefited from it. The question raised is now one of political imagination. To go back or to go forward! That is the question being posed by the “wise men”.

The US was for many years a federal state without a central bank, the EU (or rather the EZ) is an association of sovereign states, i.e not a state, with a central bank with the attributes of such an institution appropriate to that institutional situation. The interim solution can only be a mechanism for the “joint production of confidence” as advocated by Winkler.

“The implication of this analysis is that the ECB has more than enough “capital” to underwrite the peripheral bond markets, without this being inflationary in the long run. In a single nation state, it would probably prove irresistible to bring forward some of this capital from the future into the present, and then use it to purchase government bonds to resolve the crisis.”

I was attempting to make a similar point in the ‘not getting round to repaying the ELA’ thread. The promissory note seems to me to be a supposedly Irish print – not through creating money to buy a bond, but through with similar effect, sucking a bubble of money from the future together with a promise to raise the tax revenue to deflate that bubble as the future rolls out.

Is it being argued that restructuring or write-off of the pro note is not a form of default, or is it being argued that it is, but it doesn’t matter?

Wel Duh! Central Bank interventions are either funded by real money or seigniorage.

Why the sudden need for economics 101 ?

In this particular case, I can’t imagine how the ECB would fail to make a substantial profit on the whole thing. Italy has a primary budget surplus, and in normal conditions should not be anywhere near to 7% interest rates.

@Desmond B

Gavin doesn’t think it is any more economics 101 than anything else that it seems OK to discuss in great detail, see extract below that John McH missed out.

I would wager you the parallel currency note Colm now owes to Seafoid that less that 1% of EZ politicians would actually understand Gavin’s post.

“Of course, all of this would be inevitably very obscure to the general public. And it may also be obscure to the German government and even to the board of the ECB itself, since the underlying economics are not widely understood. Germany has usually opposed using seigniorage because of concerns about inflation, and about the moral hazard involved in letting debtor countries escape from the consequences of their own previous actions. If it understood the full nature of the resource transfers which the process involves, it would probably oppose it for that reason too, though it does not have the constitutional authority to prevent its use.

Neither Germany not the ECB wants to fire the silver bullet. That represents powerful opposition – even if they are wrong.”

@ All

Just to confirm that the Google Translate version of the Regling interview is pretty accurate. The question is now whether France can stay out of the line of fire, the “accidental” release of a premature downgrade note by S & P being a rather curious event, to say the least.

@ All

At the risk of over loading the boat but to complete the picture for this particular episode in the euro saga, a tale of an unusual currency living in trying circumstances.

Incidentally, it strikes me as a non-expert that the idea of buying only the bonds of countries already in difficulties makes absolutely no sense, as others more expert than I have already pointed out. Will Regling come up with the solution? Watch the next exciting episode unfold in the markets on Monday!

Gavyn Davies discussion is too neoclassical and does not allow for macroeconomic feedback loops and coordinated “bad” outcomes. Without the ECB as LLR, global investors worry that Italy’s government bonds might not pay off, refuse to purchase them, raising Italian rates on new rollover debt, and making Italy’s big debt burden unsustainable. This in turn hurts economic activity in Italy and elsewhere as growth stutters, worsening the Italian government’s fiscal situation. The ECB can change the dynamic by agreeing to step in to the market for outstanding Italian bonds, thereby lowering rates on new rollover debt. It is at feasible that this could be at no cost or even net economic benefit to Germany. Davies starkly neoclassical treatment misses essential aspects.


You raise an important point about multiple equilibria; though, in fairness to Gavyn Davies, I think he is well aware of this. This earlier blog post is also worth a look:

Although there is a good chance that Italy is facing a liquidity problem, such problems tend to come about when their are doubts about solvency. I don’t think it can be denied that ECB does faces a risk of losses and must also be concerned about weakening Italian incentives to reform by relieving the market pressures.

Given the stakes, I believe this is a risk they should (must?) take, while keeping the pressure on Italy to do its part to pull back from the solvency danger zone.

I have little doubt that we in Ireland would have little trouble appreciating the net transfer risk from ECB interventions if we were one of the stronger members of the eurozone.


“Is it being argued that restructuring or write-off of the pro note is not a form of default, or is it being argued that it is, but it doesn’t matter?”

I can’t see how a write-off of the pro note — and thus a failure to repay the ELA — would not be a default. The Davies piece is a not a bad reminder that we are dealing with real money when you don’t repay a central bank.

Restructuring ithe prom note seems to me to be different matter (though you could say it is a matter of degree). It again it really comes down to restructuring the ELA. Just as changing the terms of the loans from the EFSF/EFSM was not considered a default, I don’t think that a negotiated agreement with the ECB/CBI that extends the ELA, say, should be viewed so either.

@John Mc Hale
If a failure to repay 50 bn of Greek sovereign debt is not a default, I don’t see how anyone is going to quibble about 30.6 bn of promissory note. It’s not as if there are any CDS on it to worry about…

I think rosary beads might be more appropriate for the ECB. Italian bond spread to bund experienced a 10 sigma move on friday.

As to how unlikely a 10 sigma move is:
that’s 1.523970*10^-23
whatever that means, but I suspect it is quite unlikely.

Luckily Italy is only illiquid and we know this is so because we have been told it is not a solvency problem. Oh wait, I seem to recall a dead Finance Minister saying that somewhere before…

ECB is not a commercial bank. It does not go bankrupt when it’s capital goes negative. Because it does not go bankrupt, it operates normally even with negative capital. So there is no need to recaptalize it. Why would you do that, when you do not have to do that?

If losses stay on the ECB balance sheet, is there transfer of resources?

Economy is not zero-sum game. It is possible to produce more resources when financial obstructions are solved. Therefore, solving of the euro crisis does not lead to transfer of resources. It leads to production and consumption of more resources.

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