Year: 2012

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.

Redistributions in a monetary union

Karl Whelan has a good post on the exaggerated fears of ECB insolvency, rightly pointing out that standard ideas of bank or non-bank-corporate insolvency do not transfer well to a central bank with the power to create liabilities at will.

But I think Karl’s post underplays the importance of potential redistribution effects of monetary policy within a monetary union.   (Although the ECB’s stress on price stability gets most attention, my sense is that the avoidance of redistributions between members plays at least as important a role in their thinking.)   One way of seeing this is to recognise that the amount of seigniorage-related revenues available for ultimate distribution to member governments is fixed by the inflation target (given real growth and other determinants of the change in money demand.)   Losses on asset purchases will lower these revenues. 

This also relates to discussions of design flaws in the euro, and especially the absence of effective bailout mechanisms.   The revealed fragility of creditworthiness within the monetary union shows the seriousness of this flaw.  But the “no-bailout-rule” was there to reduce the risk of redistributions, and without it many countries would not have signed up.   The revealed design flaw will have to be fixed if the euro is to survive.   Yet I think there is a better chance of effective negotiated change if legitimate concerns over redistributions are recognised.

The European Sovereign Debt Crisis

I have a survey paper on the fiscal dimensions of the euro crisis in the Summer 2012 issue of JEP.

Link here

Simon Wren-Lewis, the EMU chess game, Italy and the IMF

Simon Wren-Lewis has a nice post here. The whole situation makes you wonder whether, despite all the ECB’s talk of independence, there is a major Western central bank more subject to political constraints anywhere in the world.

I would add a couple of points.

First, the ECB and the rest of us are fixated on what will fly politically in Germany; but there are 16 other member states in the Eurozone, and not all of them are as pliable as little, eager-to-please Ireland. In particular, I have always thought that there were two reasons to avoid having Italy enter a bailout programme: not just the fact that EFSF/ESM won’t have enough money, but the fact that if this happens, Italy may decide to leave EMU. The reason why economists like Paul de Grauwe have been asking for ECB intervention is so that an Italian bailout becomes unnecessary; now it seems that Italy will only get ECB intervention if it enters a bailout programme. The whole thing seems upside down, and people are playing with fire here. Despite its large debts, Italy wouldn’t be having these difficulties on the market if it wasn’t in EMU: to ask a big, important country with a sense of its own dignity to give up sovereignty — and potentially enter the same death spiral as Greece, and now apparently Spain — simply so that it can remain in a single currency that isn’t working seems like a bit of a stretch to me.

Second, I agree with Simon that the ECB’s worrying about the moral hazard facing states like Italy in a situation like this is pretty stupid. (I would add that it is also wrong because it mixes up fiscal and monetary policy. Let the ECB stick to monetary policy, and let governments, individually and collectively, stick to fiscal policy.) But in our dysfunctional, destructive monetary union it may indeed be politically necessary for the ECB to insist on fiscal policy conditionality before doing the job of a central bank. Forcing Italy into a bailout programme seems like a particularly dangerous way of doing this, however.

There is a better way I think. The IMF is signaling that Spain and Italy are doing all that could be reasonably asked of them right now. Surely if the IMF is willing to certify that a country is running a sensible fiscal policy, this should be enough to allow the ECB to do what needs to be done?

UPDATE: Francesco Giavazzi is quoted here as making an obvious and very important point: for an unelected technocrat like Monti to steer Italy into a bailout programme, with the consequent loss of sovereignty that would be involved, prior to elections, would be unacceptable.

Draghi’s bold move in euro chess game

The FT editorial provides a “fair and balanced” assessment of this initiative – here.