Some thoughts on bond buying

Michael Hennigan noted fairly enough that my previous post was a bit on the arcane side.   I’m afraid he will see this one as no better.  

I think it is worthwhile to take a step back and think about how ECB bond buying could have positive effect, and to think about the effectiveness of past and possible future bond-buying programmes in that light.   A useful starting point is to recognise that the willingness to pay for a bond with a given face value and coupon rate depends on the “risk free rate” and the perception of default risk.   If everyone agreed on the default risk, then the demand curve for bonds would be perfectly flat.   If a bond buying programme did not actually change the perception of default risk, then bond buying would have no effect on secondary market price and thus on yields.   (A useful way of thinking about official bond buying is that it shifts the market supply curve leftwards; if the market demand curve is horizontal, then there will be no change in price (and thus yields)).  

However, if there are varying perceptions of default risk, then – even if the bond buying programme itself does not change anyone’s perception of default risk – the programme will raise bond prices (and reduce yields), as the market moves up along a downward sloping demand curve.   (The differing perceptions of default risk is what makes the demand curve downward sloping, given the resulting variation in willingness to pay.)   My sense is that this is what broadly happened in the first phase of bond buying.  The weak commitment to the programme did little to change actual perceptions of default risk.   Thus, while purchases were somewhat effective in reducing yields, the positive impact was very limited, as ultimate default risks were left largely unchanged.  The programme ended up in failure.

It seems Mario Draghi is well aware of this, and he wants any future to operate quite differently.   The key is to provide a credible commitment to keep yields down and ensure that expectations of a “bad expectational equilibrium” do not take hold.  But there is understandable concern over moral hazard.   Although some European policy makers seem to have a difficult time giving up on market discipline (even after Deauville), I don’t see how we can pull out of the crisis unless the perception of default risk is kept low.  This leaves “conditionality” as the only feasible disciplining device.   But I don’t see how the ECB would be in a position to make a credible commitment to do what it takes unless this alternative disciplining device is in place, which explains the requirement that benefiting countries enter a programme.  

The goal should be to take risk of sovereign debt restructuring off the table as far as possible in any future programme.   (The example of Greece shows that the possibility of restructuring cannot be completely removed; and it did the credibility of the Trichet-led ECB no good to make ludicrous statements that restructuring was impossible.)  Mr. Draghi’s (vague) commitment to revisit ECB seniority can be viewed as backing up this approach, so that even in the low probability event that there is a restructuring, the losses would be shared with official creditors.  

(As an aside, I think that a major factor behind the fall in Irish yields is the that, even if there is need for a second programme, the risk of a debt restructuring being part of that programme has fallen significantly.)  

Overall, Mr. Draghi seems to moving in the right direction.   Let’s hope he can deliver.

10 thoughts on “Some thoughts on bond buying”

  1. It’s hard to credibly rule out restructuring while many EU countries are stuck with a combination of high debt, low growth and levels of unemployment damaging to social cohesion. Another five years of this, and people across the EU’s Member States must start to feel it is intolerable – something the bond markets must understand well.

    Possibly the most credible way to take restructuring off the table for all except Greece would be, paradoxically, to have the mother of all restructurings.

  2. Restructuring may seem a process that would mainly hit people like hedge fund mangers. However, it’s private sector workers across Europe who would again be on the frontline in the pain stakes.

    Simon Johnson gave testimony on the euro crisis to a Congressional committee on Aug 1st.

    The grim but incisive analysis of the former chief economist of the IMF is well presented and easily digestible for non-economists. He is also is aware that headline Irish data should not be taken at face value.

    http://www.iie.com/publications/testimony/johnson20120801.pdf

  3. Draghi concerned abut the risk of convertibiliy…”the premia that are being charged on sovereign states borrowings…have to do…with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty – they come into our mandate. They come within our remit….Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.”

  4. Michael H
    I suppose no public sector workers ever have private pensions in Europe? Or indeed here? They all wait doing the crossword from el paid, or thr times, and clock in and out waiting to accumulate a GOLDPLATED DEFINED BENEFIT UNDERPRIVISIONED IT’S TERRRIBLE TERRRRRIIIIIBBBLE pension. No part time PS employees or ones who joined late, or women doing AVCs exist. All pensions are private sector so they will suffer. When instead the public sector should, by dint of existence , suffer. Their suffering will, in your magic realist world, make the eroded private pensions better. Or something.

  5. @John McHale

    ‘This leaves “conditionality” as the only feasible disciplining device. But I don’t see how the ECB would be in a position to make a credible commitment to do what it takes unless this alternative disciplining device is in place, which explains the requirement that benefiting countries enter a programme.’

    I cringe every time I see the term ‘moral hazard’ following the odious socializaion of financial system debt on the citizen serfs – immoral hazard. I view ‘Conditionality’ at this time and in context as first and foremost designed to fit Angela’s flawed narrative so that it can be sold to the Geman Citizenry – and both Angela and Wolfgang have since come out in support. If one observes the make up of the drafting team this is fairly obvious … see below from Der Spiegel … and also see the continuing power dynamic of Gaullism with this German administration out Gaulling the long fellow by a mile …

    ‘ECB Executive Board members Jörg Asmussen of Germany and Benoît Coeuré of France began to develop a version of the program that could placate critics’ doubts. The effort also involved Thomas Wieser, permanent chairman of the Euro Group Working Group, as well as senior German officials Thomas Steffen of the German Finance Ministry and Nikolaus Meyer-Landrut of the Chancellery. Finance Minister Wolfgang Schäuble, who met last week with his American counterpart Timothy Geithner on the German resort island of Sylt, was also kept constantly in the loop.

    The group came up with a classic compromise: The ECB will intervene in the bond markets so as to fulfill Draghi’s London promise, but it will also require the countries benefiting from the action to continue with reforms.

    http://www.irisheconomy.ie/index.php/2012/08/06/simon-wren-lewis-the-emu-chess-game-italy-and-the-imf/#comment-317501

    Time and Context always matter. So does Power.

  6. @all

    Speaking of Politics and Power PAUL GILLESPIE has an insightful piece in today’s IT – especially on the Alternative Admin in Germany and the role of leading intellectuals …. European Social Democracy is certainly not dead!

    ‘Systemically this is an economic crisis of banking, refinancing and institutional deficits. But that it will be resolved politically is often underestimated in economic comment. The systemic problems faced by the euro may prove irresolvable, so that it will fragment or collapse. If not, the political will may be found to put in place a deeper institutional framework to allow it survive.


    Such constraints of domestic politics in dealing with the crisis have provoked an impressive intervention from the German philosopher Jurgen Habermas, along with two other authors, in the influential German daily Frankfurter Allgemeine Zeitung, which editorially pursues a strict monetarist line on the euro. They see the need to link up domestic politics with transnational EU bargaining on the euro and also, crucially, to citizen outrage about the loss of democratic control over this, also expressed in protests against austerity.

    …Interestingly their piece has been echoed and endorsed by the German Social Democrat opposition, whose leader Sigmund Gabriel called this week for Germany to end its opposition to pooling euro zone debt in exchange for mutual budgetary oversight and joint fiscal policy.

    http://www.irishtimes.com/newspaper/opinion/2012/0811/1224321995747.html

  7. @ John McHale

    The debate has moved on from what the ECB can do to what countries – and notably Italy – can do for themselves cf.

    http://blogs.r.ftdata.co.uk/brusselsblog/files/2012/08/Finland-CoveredBonds.pdf

    According to the blog in question, following the recent meeting between the PMs of Finland – the author of the non-paper – and Italy, the latter has bought into the idea of covered bonds putting up a collection of non-vital state assets.

    An idea for Ireland? No doubt the junior partner in the current odd couple governing the country will find some difficulties with it.

  8. It seems extraordinary to have a discussion about ‘default risk’ without any mention of the level of government debt in those countries with high yields.

    What are we to make of Spain’s relatively low level of general government debt compared to the US, UK – compared with it’s high bond yields.

    Surely this implies the problem is Europe is a liquidity problem, rather than solvency!

  9. @ JMK

    FYI in case you missed links on other threads.

    http://www.iie.com/publications/testimony/johnson20120801.pdf

    Notably;

    “We should not underestimate the damage these steps have inflicted on Europe’s €8.4 trillion sovereign bond markets. For example, the Italian government has issued bonds with a face value of over €1.8 trillion. The groups holding these bonds are banks, pension funds, insurance companies, and Italian households. These investors bought them as safe, low-return instruments that could be used to hedge liabilities and provide for future income needs. It was once hard to imagine these could ever be restructured or default.

    Now, however, it is clear they are not safe. They have default risk, and their ultimate value is subject to the political constraint and subjective decisions by a collective of individuals in the Italian government and society, the ECB, the European Union, and the International Monetary Fund (IMF). An investor buying an Italian bond today needs to forecast an immediate, complex process that has been evolving in unpredictable ways. Investors naturally want a high return in order to bear these risks.”

    All the same investor has to do with regard to a sovereign government in control of its own currency, either heavyweights such as the US and the UK, the economic performance of which is a secondary concern, or efficient smaller countries such Sweden, where it does, is to assess the balance the government will strike between various options, including printing sufficient currency to pay back its bonds.

    The truth almost too terrible to contemplate for the debtor countries within the EA is that they are effectively borrowing in a foreign currency outside their control.

    These comments are based on no particualr expertise but on a reading of what various economists have been writing and on which a consensus appears to be emerging.

    The “collective of individuals” has to be replaced with something approaching the prerogatives of a sovereign government if the crisis is to be overcome. There also appears to be an emerging consensus on this i.e. the nature of the problem, if not on how to resolve it.

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