Managing the Budget with High Debt and No Currency

A sovereign state with low debt can access liquidity through the markets. There are limits and they will be reached when the debt ratio begins to send out distress calls. Until that (unknown) point, there are, in effect, un-borrowed foreign exchange reserves. With an independent currency liquidity can be created for government or banks without external conditionality. There are limits here too and creating excess liquidity brings inflation risk and exchange rate pressure.
With high debt and hence uncertain access to bond markets a short-term expansion cannot safely be financed through debt sales without constraining capacity to repeat the procedure. Without a currency either, the creation of liquidity is conditional on the cooperation of the foreign central bank. If its conditions include constraints on fiscal action there can be no stabilisation policy – no exchange rate, no monetary or fiscal discretion.
Most Eurozone governments can borrow in the markets at low rates, courtesy of QE, despite historically high debt ratios. In the absence of QE the perception of capacity to borrow could diminish rapidly. Availability of QE is in any event not automatic – there is none for Greece, for example. There are also unclear conditions on ELA creation by national CBs. Consent from the ECB can be withdrawn arbitrarily or may be permitted only on penal conditions, such as pay-offs to unguaranteed creditors of bust banks.
The Eurozone governments with high debt face an illusion of policy space in current circumstances, with apparently easy access to debt markets. The constraint appears to be the EU rules about budgetary limits, as long as QE lasts.
But QE will end at some stage and the constraint becomes the market demand for sovereign debt. The design problem for fiscal policy (the only stabilisation tool available) is to manage the trade-off between using it now and having less to use later. Since the election Irish politicians have found agreement on two policies: (i) that the European Commission should be lobbied to relax the budget rules and (ii) that government should borrow ‘off balance sheet’.
Policy (i), lobbying the Commission, sacrifices future budget flexibility explicitly. The inverse demand curve for sovereign debt is r = f(D) where D is the debt ratio. Unless f(D) is flat the sacrifice is real. Moreover f(D) is unknown, although known not to be flat. Unless sovereign bond buyers are unable to count (ii), hiding sovereign liabilities, is just gaming the Eurostat debt definition. This definition (gross general government debt to gross output) is not a serious measure of debt servicing capability and, after QE, a sovereign could easily be inside some EU limit and unable to borrow. Eurostat does not lend money.
There are arguments for battling to borrow: interest costs are low and it is an article of faith that high-value public investment projects are plentiful. The trade-off (looser policy now versus the risk of ill-timed tightening later) would look better if the economy was becalmed, multipliers high, debt ratios modest, macro-volatility historically low and the foreign central bank known to be benign. None of these conditions applies currently in Ireland.
There is a case for using the QE respite to borrow reserves, accepting the negative carry, as NTMA appears to be doing. The case for deferring the attainment of budget balance is harder to see.

The ECB’s Inflation Target

The Eurozone HICP inflation index for February was at roughly the same level it had reached in the early months of 2012. That is to say the inflation rate has been essentially zero for four years.
The cumulative impact of this undershoot on the real burden of debt is getting to be very serious. The ECB’s own forecasts are for just 0.1% in 2016, 1.3% in 2017 and 1.6% in 2018, so they expect the undershooting to continue. By this time next year the price level will have been flat for five years. If GDP deflators had risen at 2% per annum for those five years various indebted countries would have knocked ten points off debt/GDP ratios, other things equal. So the ECB policy failure has consequences and has penalised the countries most heavily indebted.
Unlike the situation in the UK, the USA and other inflation-targeting countries there is not even a clear figure. The phrase (intoned at every Draghi press conference) is ‘below, but close to, 2%’. Why so coy? What does ‘close to’ actually mean? Will the 1.6% predicted for 2018 be deemed to have done the job?
The treaty talks only about price stability so the choice of target is entirely a matter for the ECB Governing Council. The tortured phraseology looks like a compromise – the sound money people getting the ‘below’ part and the rest getting the ‘but close to’. The 2% number had to get a mention, since various central banks had settled on an explicit 2% figure. It would hardly have been feasible to publicly declare a lower target number like 1% and would have had market repercussions. Whichever scribe came up with the form of words has hopefully been promoted.
Suppose the measures announced last week have their desired impact and Eurozone inflation reaches somewhere deemed ‘close to’ 2% in 2018. By that stage the heavily-indebted countries will have been short-changed substantially on real debt burdens. The remedy would be to raise the target, say to 4%, for five or six years in order to compensate, as Olivier Blanchard proposed when he was at the IMF. The indebted countries would be remiss not to push for this when the time comes, assuming the show is still on the road.

Save the Eurozone – Scrap the €500 Note

The Eurozone, Japan, Switzerland and some Scandinavian countries now have negative official interest rates, so they charge commercial banks for holding excess funds at the central bank. The idea is to incentivise them to lend more money instead into the real economy. This has not really been happening: business firms are too nervous to borrow and do not feel the need for extra productive capacity. The European Central Bank is considering whether its charge on bank credit balances should be increased to power up the incentive, that is, whether the negative rate should be even more negative. There are numerous snags attaching to this latest venture into unorthodox policy.
The first is that commercial banks, whose balance sheets remain fragile, find it very hard to make money when interest rates get this low. Healthy bank profits are hardly a priority for most people but loss-making banks are not a very attractive prospect either. The other problem is that negative official interest rates mean that monetary policy is already reaching its limits. Economists have long written about the ‘zero lower bound’ for interest rates: nobody will hold deposits at a cost and will resort instead to cash. Interest rates on demandable deposits are already zero in Ireland (or 0.01% to be more accurate) and some Swiss banks are now levying a charge. If you deposit €1000 they will pay you back only €999, or €995, a year from now. This is not an attractive deal and people will prefer to keep their money in banknotes.
The trouble is that most bank deposits by value are in amounts much larger than €1000. Many business corporations, nonbank financial companies and pension funds keep deposits in the multiple millions. They cannot stuff the filing cabinets with physical banknotes. But they are not captive customers of the commercial banks either. If they can find somebody trustworthy to hold banknotes on their behalf it might be a better deal even if there is a storage cost. It appears that storage costs could be cheaper than the negative interest rates now threatened, particularly given the availability of large denomination notes such as the $100 bill or, even more attractive, the €500 note in the Eurozone. You could fit a million easily into a briefcase in the form of €500 notes. The ECB’s negative rate is currently 0.3% and it may penalise depositors even further at its next monetary policy meeting on March 10th next. Wholesale interest rates on large deposits will inevitably follow the ECB rate. There have been calculations that storing millions in the form of €500 notes would cost less than the likely wholesale penalty if the ECB goes even more negative.
So somebody needs to come up with a cunning wheeze to escape this latest policy cul-de-sac and there are active proposals to, you guessed it, abolish the €500 note. It would not be acceptable to explain that this was necessary because of another policy misadventure, so the spin coming out of both Brussels and Frankfurt is that the €500 note is mainly used by criminals, and since nobody likes criminals, it has got to go. The coincidence of this discovery with the dilemma over negative interest rates is just that, a coincidence.
The logic is impeccable at first glance. Criminals use €500 notes, ban them and this will inconvenience the criminals. Like it did with machine guns. Ban them and, oops, the only ones with machine guns are criminals. Various international law enforcement agencies, including Interpol and Europol, have confirmed that the €500 note is popular with money launderers and drug dealers and there is no reason to doubt them. But there are many billions in €500 notes out there already and the ECB can hardly cancel them. They will continue to circulate in the shadows. There are lots of non-criminal users of large notes, not just horse dealers and bookmakers in Ireland but also wholesale traders in countries outside the Eurozone with dodgy currencies and unreliable money transmission systems. As much as half of all €500 notes is believed to circulate outside the Eurozone, especially in the Balkans, Turkey and Russia. Its predecessor was the German 1000 Deutschmark note which circulated widely in these places and the ECB version was consciously introduced so as to facilitate existing users.
As for the mafia, there have been prosecutions of numerous banks for facilitating their illicit transfers and it is hard to believe that the withdrawal of the largest ECB note will inspire their professional retirement. Readers will recall the spin justifying depositor haircuts in Cyprus including the assertion that the money belonged to the mafia, Russian chapter. They survived.
The proposal to scrap the €500 note is further evidence of the absence of a serious Eurozone macroeconomic policy.

The Euro Debate and the Abuse of Language

Defenders of the Eurozone’s initial design, subsequent management and purported reform invariably refer to the system as a ‘monetary union’. So do academic commentators including the authors of the recent Vox piece on the origins of the crisis. Whether intended or unconscious, this is an abuse of language.

Monetary unions do not experience selective bank closures, the re-introduction of exchange controls or the numerous other manifestations of financial fragmentation that have occurred before and after the Eurozone ‘reforms’. Germany is a monetary union. In 1974 the Herstatt Bank collapsed in Cologne and several banks based in Dusseldorf went down in the recent crisis. Both cities are in Nordrhein Westfalen, but there was no closure of bank branches in the state nor were exchange controls introduced by the state authorities on either occasion. Interest rates in Nordrhein Westfalen did not detach from rates elsewhere in Germany nor did bank deposits flee the state.

When the Continental Illinois Bank went under in 1984, at the time the largest-ever US bank failure, the state of Illinois was not expected to handle the fall-out. In the recent crisis the state of Delaware, home to lehmans, and the state of North Carolina, home to Wachovia, were similarly spared. The USA is also a monetary union and there is federal responsibility for bank supervision, bank resolution and the protection of bank creditors.

The Eurozone in contrast was established in 1999 as no more than a common currency area, with a ‘central bank’ responsible only for monetary policy in the aggregate, in pursuit of an inflation target. To describe it as a ‘monetary union’ is to deny that there is any distinction between a common currency area and a monetary union. If the Eurozone really was a monetary union in 2008 the history of the crisis would have been very different.

Language matters. In his 1946 essay (Politics and the English Language) George Orwell put it like this:

‘The great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink. In our age there is no such thing as “keeping out of politics.” All issues are political issues, and politics itself is a mass of lies, evasions, folly, hatred, and schizophrenia. When the general atmosphere is bad, language must suffer.’

The danger is that relentless description of the Eurozone as a monetary union deflects attention from the awkward truth that it is not, and from the political unwillingness to make it so.

Dublin Economics Workshop Conference – Final Call

The Dublin Economics Workshop will hold its annual economic policy conference at the Hodson Bay Hotel in Athlone on October 16th and 17th next. Some slots are still available and proposals in any area of economic policy are welcome. They should be forwarded as soon as possible to

Programme and booking details will be circulated shortly.

The Dublin Economics Workshop is kindly sponsored by Dublin Chamber of Commerce.

Call for Proposals DEW Conference 2015

The Dublin Economics Workshop will hold its annual economic policy conference at the Hodson Bay Hotel in Athlone October 16th and 17th next. Proposals in any area of economic policy are invited and should be forwarded, ideally before September 4th, to both of the following: and

Programme and booking details will be circulated in due course. The Dublin Economics Workshop is kindly sponsored by Dublin Chamber of Commerce.