A European Solution to a European Problem – It Might Work

The latest attempt by the ECB to get a grip on the Eurozone crisis might work. It has the potential both to push sovereign market yields toward sustainable rates, and to block self-fulfilling institutional bank runs in which corporate deposits move to stronger Eurozone countries, draining weaker member banking systems of liquidity and credit.

Colm McCarthy was keen on a “reverse tap” in which the ECB enforces a maximum yield (minimum market price) on Italian/Spanish/etc sovereign bonds using its money-creation potential to back up this policy. The problem with his plan, in my view, was the lack of a surveillance mechanism to ensure the funded countries were continuing their needed restructuring. Germany would not accept that solution. My own preference was for the IMF to serve as conduit for sovereign funding via official IMF programs backed by ECB-funded bonds. Colm criticized this as an unnecessary intermediation by the IMF in a problem that needed to be solved by Europe.

The new ECB unlimited-three-year bank funding strategy uses the banks themselves as the monitor for sovereign discipline. It also provides direct bank liquidity so that the slow-motion institutional bank run phenomenon is less likely to lead to the negative feedback loop (corporate depositors distrust the PIIGS banks, PIIGS banks lose liquidity and restrict credit flow to their national economies, PIIGS national economies slow down due to shortage of credit, PIIGS banks suffer due to national economic slowdowns). Actually the “G” does not belong in this acronym anymore since it is a separate case. Perhaps PISI? Commercial banks in the PISI who lose corporate deposits to Germany or elsewhere can replace them with even cheaper funding from the ECB.

Might the new ECB strategy work?

26 thoughts on “A European Solution to a European Problem – It Might Work”

  1. To my mind the saddest thing is that the notion of the strategy “working” has fallen victim to the soft bigotry of low expectations. Nobody expects Europe to avoid a nasty recession, probably followed by years of sluggish growth — a jobless recovery. But if the banking system survives more-or-less intact, we’ll be told the strategy worked.

  2. Here’s where I think you get a problem.
    In normal conditions the ECB lends to banks who lend to businesses who create growth.
    In these conditions the ECB lends to banks who will either hoarde the cash or buy govt debt. But buying govt debt does not generate growth like investing in business does especially when the bonds are being used to roll over debt and are accompanied by forced fiscal contraction.
    Bottom line is that by lending in this way growth will always lag bond yields so the debt spiral continues.

    The money will not circulate properly

  3. Well the banking system has been incapable of financing core wealth creation for a long long time – it prefers to finance consumer durables hoping the wealth will magically spring out of the ground.
    Each of the previous post Great war recessions has created enough oil surplus so that more consumer durables can be provided with credit again.

    Well I would contend that this will not work this time – wealth creation is now much more capital intensive.
    Before we spend we need to invest , this is harder then what we have come to know as normal capitalist practise but if it was easy it would have been done already.
    The current banking system strung out on credit junk is a sad 20th century anachronism – we might as well wait for Godot.
    Money & not credit must be spent into existence so that it can create a new wealth surplus that we can then spend.

  4. @Gregory Connor

    It is certainly a long way from the pejorative strategy of weaning addict banks from ECB dependency. But there is a critical element still missing.
    An EU wide bank resolution scheme that protects depositors.

    Commercial banks in the PISI who lose corporate deposits to Germany or elsewhere can replace them with even cheaper funding from the ECB

    Yes they can but if the reason for moving the deposits is that they suspect that the bank may be insolvent or risky as distinct from illiquid, then their deposits are still not guaranteed. So the ECB strategy while helpful will not allay those concerns.

  5. No, it will not work. Why are Northern European banks, which are drowning in excess savings, refusing to fund Southern European banks, which are short of savings vs. their lending? Because the Northern European banks expect the Euro to break up. As a result, they are stashing their excess savings as deposits at the ECB (more precisely at their national central banks, generating the famous Target 2 imbalances), leading to a fall in the velocity of money and thus a monetary contraction in the absence of an adequate reaction of the ECB.

    And why do the Northern European banks expect the Euro to break up? Because countries such as Italy are insolvent? Bullshit! Because they understand that massively different funding conditions, whether for private or for public borrowers, are totally untenable in the longer term in a monetary union. I do not have to explain that a massive divergence of funding conditions has already taken place for a major segment of the market, namely sovereign borrowers. Due to the collapse of the North-South interbank market, we are also starting to see a divergence of funding conditions for private borrowers as well.

    As the ECB refuses to intervene adequately to achieve a re-convergence of funding conditions across the monetary union, only a correction of the macro-imbalances might bring back some convergence of funding conditions. Might. And anyway, such a process will take years. The Euro will not survive that long. Democratic processes will see to that.

    In fact, the Euro is a zombie currency. There is no monetary union anymore. The Euro has already broken up, but it has not yet noticed.

  6. @Ingognito

    thats very good summery

    European banks seem to be a lot weaker than a lot people thought they may use the LTRO to hoard money but i think they will be very reluctant to purchase peripheral bonds with the risks of default

    it may be coming to a head in the financial system is at a near breaking point with head winds in China and Japan also surfacing and Oil pricing is at far too high levels to enable the west to recover

    the ECB has been far too slow to act and now i fear it is too late it looks to me that in the new year it will be a every Country or maybe every man for himself

    i am very fearful of what the start of 2012 has to offer

  7. Massive Lending Operation

    ECB’s Risky Plan to Flood Banks with Cash
    By Stefan Kaiser

    ECB President Mario Draghi told a committee of the European Parliament that Europe’s banks faced major dangers in the coming months. “The pressure that bond markets will be experiencing is really very, very significant if not unprecedented,” Draghi said.

    It will be a tough year for banks. In 2012 overall they will have to pay back €725 billion ($953 billion) in debt, of which €280 billion will fall due in the first quarter alone. They will have to borrow fresh money to service this debt, but it’s almost impossible for them to raise that money in the private market. Most of them have large holdings of European government bonds on their balance sheets, so they don’t have the mutual trust necessary to lend each other large sums of money.

    “The interbank market is pretty shut,” said Dieter Hein, a finance expert at Fairesearch, an independent research company for institutional investors, banks and brokers. “Virtually no one outside is lending any money to euro-zone banks any more.”

    http://www.spiegel.de/international/europe/0,1518,805135,00.html#ref=nlint

    It buys some time for financial system to tighten its grip on the sovereigns. Its own Big Black Hole hasn’t gone away.

  8. @ clintideal

    Thanks. I would like to add the following. I personnally believe that it is possible to have a functional monetary union. But not under the present arrangements. What is really needed is a new monetary compact, not a new fiscal compact. The basic principle must be that the ECB must defend the sovereigns as long as they carry out whatever macro-economic policies are mutually agreed. I do not give a shit about the level of public debt or budget deficits. There have been many situations were either or both were very high, while completely adequate from a macro-economic point of view. See the US today for example. Or Japan.

    But I see no chance of such a monetary compact being adopted. Therefore, the sooner the Euro formally breaks up, the better. With the backing of its own central bank, I dare to bet that a country such as Ireland would quickly recover market access. Not only that. I also believe that bond yields would fall to very low levels (say 2-3% for 10Y bonds). In an deleveraging economy, there is no reason why bond yields should be very high, as we can see in the US.

    Same for Italy and Spain. I am also far from convinced that the new currencies would depreciate much. Except for Portugal and Greece, due to their large current account deficits.

    Germany & co would probably have a very sharp reappreciation, leading them to fall into a deflationary spiral and a liquidity trap.

  9. @Incognito
    Most people think that the root cause of the problem was the fact that the same interest rate were applied throughout the EZ ,regardless of the risks ,hence the massive sovereign deficits of Portugal and Greece (Belgium and France to a lesser extent) and the humongous housing bubbles of Spain and Ireland .
    Now you seem to imply that we should go back to pre-2008 era.I do not think it is possible or desirable.
    There is a large spread of interest rates between the American states and this does not seem to perturb the Fed.

  10. I don’t think there is going to be any magic bullet. It’s going to be a long slog back to any kind of balance and there will be years of austerity and very little growth as the debt overhang gets worked out . If China and the US slow down then it will be even more difficult.
    The whole financial model is broken and the banks won’t give it up.

  11. @DoD

    as per your post from Der Speigel it seems to me that there are now so many triggers that can off at any moment in the system that regulations will go out window in the fire fighting operation that is taking place on daily occurrance
    ie the LTRO was not for the sovereign bonds but for the banks as they are weakest link

  12. Great breakdown Incognito.
    I must say I am very surprised.
    All the Euro had to do was devalue against Gold , not the $.

    Any oil surplus created via austerity is now just flowing to the US & its $ pegged twin China.

    It seems the Goldman / US Treasury boys cannot soil their own nest much more & so therefore shat all over Europe in a effort to save themselves – giving us no Euros to pay the debt.

    Its all very smelly.

  13. @ Overseas commentator (I am as well)

    “Most people think that the root cause of the problem was the fact that the same interest rate were applied throughout the EZ ,regardless of the risks ,hence the massive sovereign deficits of Portugal and Greece (Belgium and France to a lesser extent) and the humongous housing bubbles of Spain and Ireland .”

    I doubt that, but that would merit deeper thoughts. It is not so easy to explain what happened during that period. Why did the common funding conditions across the Euro area lead to housing bubbles in Ireland for example, but not in Germany? Not very clear to me.

    “There is a large spread of interest rates between the American states and this does not seem to perturb the Fed.”

    Yes, but the weight of the States in the US is absolutely not comparable to that of the countries making up the Euro Area. If a US State goes bankrupt, it will not bring down its whole banking system with it (and vice versa – see Ireland and Iceland). The deposit guarantee will continue to function. Most public services as well. There are large interstate transfers. Etc etc etc.

  14. @DOD

    imagine a hollywood film blockbuster ie wall street but teeth the real story
    i`m afraid very few people would follow it as it would seem a completely
    bonkers story line to follow

    REVENGE OF THE BONDHOLDERS

    REVENGE OF THE BONDHOLDERS 2

    i could could go on but i think you get the jist

  15. @Incognito

    A sharp analysis – agree that iwell into the end-game now.

    As for why we there was a housing bubble in Ireland and not Germany I would start with demographics, the scale of net immigration and a much higher rate of economic growth. We also have a historical/cultural fascination with owning property.

  16. @ incognito
    …because Germany was paying for reunification and
    …because Germany has the highest percentage of over 65’s in Europe

    Now there are exceptions but most 65 year olds aren’t looking for a place of their own so they can get down without waking up the parents if you know what I mean…

  17. Well ECB now under serious threat, a fund manager is suing them, asking just how they got super senior status re the Greek debt the E:CB bought:

    http://on.ft.com/sCsx51

    afaik…there was no new legal agreement around the SMP purchases,and they happened in secondary market…so very hard to see how they could be super senior

    Also of course…if the ECB did manage to ram thru super senior status, they’d book a handsome profit. As far as I’m concerned the only issue now is jurisdiction/venue…a very unpleasant Christmas headache for the ECB

  18. Irish property Boom? Money supply is the culprit. Interest rates too low too long. Banks suckered by cheap money market rates. Also demographics are not an excuse for throwing out the fiduciary rule book. Big sub-prime element. Banks trying to stop Fitzgerald from “stealing their lunch” jumped on the bandwagon stoking the madness. Bank of Scotland (Ire) acting the fool. Apartments in Dubai, Detroit, London, Berlin, Moscow etc.

    Behind it all was a belief that the Government would be unable to let big banks go bust. They were right. We got screwed.

  19. Might the new ECB strategy work?

    No.

    Are Northern banks hoarding savings? I don’t know, but it seems unlikely.

    The reason we are in a credit crunch is because millions of people and corporations are desperate to de-lever their debts (except the banks of course) and governments will not let them get on with it seeking instead to induce another bubble.

    The debt based currencies have run out of suckers who will borrow money in order to keep the whole ponzi afloat. There are not enough potential borrowers in any case now. In six months there will definitely not be enough. In the meantime EZ Governments would need another 100-200 billion just to keep the government offices lit.

    The longer this goes on the bigger the disaster that inevitably follows.

  20. ‘With the backing of its own central bank, I dare to bet that a country such as Ireland would quickly recover market access. Not only that. I also believe that bond yields would fall to very low levels (say 2-3% for 10Y bonds). In an deleveraging economy, there is no reason why bond yields should be very high, as we can see in the US’

    See here for a useful set of links which explain why US yields are low.

    http://www.nakedcapitalism.com/2011/12/wray-on-krugman-and-currency-sovereignty.html

  21. @ Incognito (also post above)

    While I agree with much of what you have said, I think you grossly overestimate the potential power of an independent ICB. Patrick Honohan’s paper gives some sense of the historical constraints.

    http://homepage.eircom.net/~phonohan/BNL.pdf

    As Dork regularly notes, the EZ has been shafted, and Ireland is well and truly in the sh1t.

  22. Personally, I think it’s a mega-kick of one of the cans down the road to buy some breathing space.

    Anyway, what has the ECB really done for price stability (HT to the DTelegraph):

    “…the average cost of a Christmas dinner has gone up this year, with the price of some items jumping by as much as 50% since last Christmas.

    Turkey, wine, chicken and cheese have all gone up in price since last Christmas. Cream crackers have increased the most, by 50%. Only some vegetables (carrots and potatoes) have become cheaper.”

    On top of that, apparently the ingredients for pigs in blankets (or whatever they’re called – sausage wrapped in bacon) have also climbed dramatically.
    PIIGS in blankets…. now there’s a thought.

  23. It depends…

    There has been some reports that euro-zone banks have been raising cash by selling good assets at low prices. If the ECB allows the banks to borrow money using these assets as collateral then the assets will still be part of the assets in a failed bank. This could mean that in theory the cost (for taxpayers) of restructuring of failed banks might possibly be reduced as the good quality assets will still be around.

    I suppose it depends on the details of the ECB programme. The banks (or rather its senior employees) will do what they always do and that is try to game the system to their advantage.

    A surprising feature that does seem to be reported & never questioned:
    Business lending is cut BEFORE mortgage lending is cut? Business lending is more profitable and shorter term than mortgage lending so why would a bank with limited liquidity use its limited liquidity for lower profit opportunities where the liquidity is tied up for longer?

  24. @Gregory

    “The problem with his plan, in my view, was the lack of a surveillance mechanism to ensure the funded countries were continuing their needed restructuring.”

    I think this problem could be circumvented by linking the target rates to a sovereign’s credit rating. For example, the ECB could say it will not tolerate in the primary market 10 year bond yields on AA rated sovereigns above 4%, on A rated sovereigns above 5% etc.

    This would essentially delegate surveillance to the ratings agencies and would allow the ECB to claim they are merely guaranteeing the liquidity of the sovereign debt markets so that self-fulfilling runs on sovereign bonds are avoided.

    The problem with essentially giving money to the banks is that they are not compelled to buy sov debt with it (although the collateral incentives exist).

    Had the ECB announced a ratings based reverse tap as above, we would have seen an immediate shift in bond yields. So far, the current program has not had the same effect, but time will tell.

  25. The problem, I think, is that there is a run on assets, not that cash is no longer mobile. Reinstating (underflooring) asset values is what is required, so the ECB should, for eurozone sovereigns, throw away it’s collateral haircuts based on ratings and invert the pricing structure so longer duration bonds are worth more at ECB repo, not less as currently. Weaning the sovereign debt issuance system away from short-term rollover risk and flattening the yield curve is what is required, IMO.

    Three year money is a good start, but a range of durations and a range of open bid windows is required for this to work.

    What it does appear to show is that the foolish experiment to make sovereign debt subordinate to bank debt is over. It is sad that it is too late for us…

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