Author: John McHale

Seamus Coffey has an excellent article on resolving the euro zone banking crisis in today’s Irish Independent (HT DOCM).   For the Irish situation, Seamus puts the proper focus back on the case for extending the maturity of the promissory notes/ELA arrangements as the correct focus of negotiations.   The idea that the ESM would retrospectively cover already crystallised losses in the Irish banking system looks fanciful, and only serves to create confusion about what Ireland needs – and could realistically be provided – in order to further the shared objective of getting Ireland off external assistance.  

In the certainty of attracting vitriol in comments, I think Seamus is being a bit hard on the ECB.    The problem that the ECB faces is a bank creditworthiness crisis across a significant part of the euro zone.    In fairness, they have been willing to meet their proper function of acting aggressively as a lender of last resort to stem deposit flight.   But they can only do this if the banks they are lending to are solvent.   They have insisted that the banks be recapitalised, preferably directly from centralised bailout funds, but failing that by governments, with money borrowed from those funds.  

I think most analysts agree that the future stability of the euro zone will require a form of banking union, with centralised supervision, centralised deposit insurance and a centralised resolution regime that allows for losses to be imposed more broadly on certain classes of bank creditors.   The challenge is how to get from here to there.  In the short term, putting creditors at greater risk of losses reduces bank creditworthiness further, potentially causing the crisis to escalate.   Moreover, given the differences in the solvency of the banks in different euro zone countries, any move towards centralised deposit insurance has potentially large distributional implications across euro zone countries.   If a deposit insurance regime could be agreed behind a “veil of ignorance”, with negotiators not knowing which country they represented, it should be relatively easy to agree to such arrangements.   But alas this “ignorance” is not available.   The messy and fragile two-way process involving greater risk sharing and more credible assurances of mutual discipline will continue. 

I have been meaning to comment on the results of the Survey of Income and Living Conditions (SILC) 2010, but hadn’t got around to it with all the excitement on fiscal matters.   As has been widely reported, the survey showed a dramatic increase in income inequality, with the quintile ratio (the ratio of the incomes of the highest income quintile to the lowest income quintile) rising to 5.5 from 4.3 in 2009.   The Gini coefficient also jumped dramatically, from 29.3 to 33.9.   (A Gini of 0 represent perfect equality; a Gini of 100 represents perfect inequality – i.e. one household having all the income.)  These increases more than reversed the measured declines since the middle of the decade.  

Although these increases took place at a time of wrenching adjustment in the Irish economy, the magnitude of the increases in measured inequality is still surprising.  All the more so since the ESRI’s analysis of the 2010 budget indicated that the changes were progressive (see here for an analysis of the period 2008 to 2012).  (See also page 17 of this European Commission report on Ireland.)

The SILC is an extremely carefully constructed survey.    However, as noted in the survery report, sampling variation is unavoidable, and results must be always be interpreted carefully.   One indication that sampling variation may be an issue is the fact that the number of “household heads” with a third-level qualification or higher increased to 1,830 from 1,505 (p. 83).   This increase occurred despite the total number being surveyed falling to 11,587 from 12,641.   Thus the proportion of survey respondents with a household head with a third-level education or higher – a fraction that changes relatively slowly over time – increased to 15.8 percent from 11.9 percent.  This suggests that sampling variation may explain part of the measured increase. 

My purpose here is most certainly not to diminish the importance of inequality as an issue – quite the contrary.  And it may well be true that inequality will turn out to have risen over this recession after balancing market and post-market factors.   But those concerned with inequality might be unwise to put too much emphasis on one year’s survey results.   To the extent that the increase in inequality partly reflects sampling variation, there is a greater likelihood that it will fall again in the next survey release.   This could too easily be interpreted as indicating that recession-related inequality effects are not an issue.   Perhaps of greater concern than the results in SILC 2010 is the breaking of the recent trend of progressive budgets in Budget 2012 (see Figure 1 here).   However, we will need to see more than one budget to accurately gauge the distributional implications of Government policies. 

In the wake of the referendum result and speculation of the ESM directly injecting capital into Spanish banks, there is a lot of discussion about the possibility of Ireland “getting a better deal on its bank debt”.    It would help if people were more explicit about what they had in mind.   I would not be surprised that many in the public believe that it means there would be retrospective collective European absorption of already crystallised losses in the Irish banking system.  Although I would love to be wrong, I believe that the odds of this happening are approaching zero.   Failure to deliver such absorption would increase the sense of grievance on Ireland’s treatment in relation to the bank and bondholder/depositor rescues.   Some might argue that a sense of grievance is useful in strengthening Ireland’s bargaining position.   I doubt it; and any benefits are unlikely to outweigh the costs in reduced domestic support for Ireland’s necessary adjustment efforts.    

It is worthwhile to consider what an extension of the ESM’s role could realistically mean for Ireland.  I consider some possibilities below.   I would be interested in people’s views. 

First, if additional capital injections are needed, Ireland would have a strong case for these injections coming via the ESM.   However, this would not be a direct transfer, but a capital injection in return for a fair stake in the bank.    The advantage would be that it would reduce the uncertainty around the value of balance sheet of the State relative to State making such injections. 

Second, it is possible that the ESM could take over some or all of the State’s existing ownership stakes in the banks.  Again, I think it would be unrealistic to expect the ESM to pay more than fair value.   The advantage would again be reduced uncertainty over the value of the State’s balance sheet.   But it is again important to recognise that this would be of considerably less value than any absorption of already crystallised losses. 

Third, the fact that Ireland’s bank-rescue efforts preceded any development of the ESM as a mechanism for recapitalising banks could help Ireland get more traction on the extending the repayment schedule for the promissory notes/ELA.   (It does seem unfair to be disadvantaged for faster recognition of the reality of bank losses.)

In considering the likelihood of a deal on the promissory notes, it is worthwhile to recognise the reason for the ECB’s strong opposition.   The provision of ELA to IBRC effectively amounts to temporary monetary financing of a government.   The euro system has allowed the Irish central bank to print money to temporarily finance IBRC, but on the understanding that the funds will be repaid by the Irish State, and the money creation eventually reversed.   A monetary union could not survive with individual countries printing money on a permanent basis, as it amounts to a transfer to the country printing the money from other countries in the system.   We would and should be firmly opposed to other countries engaging in such a practice.   The ECB is therefore extremely uncomfortable with even temporary money creation.   Extending the ELA beyond the agreed schedule has, so far, been a bridge too far.   The question is whether the advantages of facilitating Ireland’s return to market creditworthiness by reducing medium-term funding needs means that they are willing to hold their noses a bit tighter and allow a longer repayment schedule.   I think there is a strong case to be made for such extended repayment schedule, but we should not be surprised that it has been so difficult. 

Fourth, an alternative to extending the maturity is for ESM to make long-term loans to the State to allow it to redeem the promissory notes.   The ECB would certainly be happy with this arrangement.   However, the benefits in terms in terms of longer maturity would have to be weighed against the higher interest rate, recognising the ultimate interest cost to the State from the promissory notes/ELA arrangement is very low.   We would have to see the details to assess whether this would be a good deal. 

I have previously referred to the dangers of a new “impossible trinity” for the euro zone: avoiding its disintegration; avoiding a significant move towards fiscal integration; and avoiding any relaxation of the current definition of price stability.  In Wednesday’s post, I held out hope that stronger mutual insurance mechanisms could follow credible mutual assurances of disciplined policies.   Here I want to revisit the possibility of relaxing current definitions of price stability.   I realise this is taboo – but one I believe has to challenged given the nature and extent of the challenge facing the euro zone. 

The move to formal inflation targeting in the euro zone, Canada and the UK (as well as informal inflation targeting in the US) followed the traumas of the stagflation of the 1970s, not least the expensive efforts in terms of lost growth and employment to bring inflation down in the 1980s and 1990s.  However, while it is understandable that governments would not want to squander such expensively bought gains, the danger is that policymakers end up fighting the last war. 

The particular constellation of problems in the weaker euro zone economies means that it will be very difficult – maybe impossible – to pull through the crisis under current arrangements.   The boom-bust cycle in capital inflows have left a number of countries with current account deficits that cannot be financed.   There is no alternative to adjustment.   Given nominal rigidities, internal devaluation is a slow and costly process, requiring deep recessions to curb the demand for imports and induce the necessary wage/non-traded price cuts.   Slow growth further undermines the creditworthiness of States and banking systems, creating damaging negative feedback loops.   The euro zone may not survive the trauma under current policies.   A higher inflation target could lower the costs of adjustment. 

The danger is that the protection of hard-won low inflation becomes a mantra, preventing a broader reconsideration of the appropriate macroeconomic regime for the euro zone that properly reflects the full range of challenges being faced.  Good macroeconomic management could become a victim of its own past success in institutionalising a low inflation-targeting regime.   The question is whether it is possible to maintain much of the achievement of inflation targeting, while putting in place a macroeconomic regime that is consistent with a path through the crisis that avoids a disintegration of the euro zone. 

It is important not to lose sight of the strong case for inflation targeting.   The benefits are not limited to low and stable inflation.  (See, for example, this account from the Bank of Canada.)  By anchoring inflation expectations, a credible inflation targeting regime allows central banks the freedom not to have to respond to temporary supply-driven jumps in prices – due, say, to oil price or other commodity price shocks.   If inflation expectations are not well anchored, central banks may have to tighten policy because of they fear second-round inflation change effects, which would result from the temporary inflation shock becoming embedded in inflation expectations.   A credible inflation targeting regime can therefore have important benefits in terms of output and employment stability.   (The financial crisis has made it clear that central banks put too much faith in the sufficiency of inflation targeting, taking a too relaxed attitude to the build up of financial vulnerabilities due to excessive credit growth.   But this is not an argument against inflation targeting per se.   Rather it points to the need to use other instruments – including macro prudential tools – to ensure stability. )

The key question is whether the benefits of an inflation targeting regime could be obtained with a higher inflation target.   While there are risks to increasing an inflation target, the institutional structures of an independent central bank with an unambiguous mandate to achieve the inflation target over the medium run should allow the important benefits of an inflation-targeting regime to be protected.  

With the euro zone facing an existential threat, it is not enough to repeat mantras about the benefits of price stability.   Recognising the full range of objectives – including the value of a credible inflation targeting regime – it is time to reconsider the appropriate inflation-targeting regime for a euro zone in crisis.

Peter Boone and Simon Johnson raise an alarm here.  

Martin Wolf reviews Germany’s options here.   From Martin’s piece:

Now turn to the second issue: how does Germany want the euro zone to be organised? This is how I understand the views of the German government and monetary authorities: no euro zone bonds; no increase in funds available to the European Stability Mechanism (currently €500 billion); no common backing for the banking system; no deviation from fiscal austerity, including in Germany itself; no monetary financing of governments; no relaxation of euro zone monetary policy; and no powerful credit boom in Germany. The creditor country, in whose hands power in a crisis lies, is saying “Nein” at least seven times.

How, I wonder, do Germany’s policymakers imagine they will halt the euro zone’s doom loop? I have two hypotheses. The first is that they believe they will not. They expect life for some of the vulnerable economies will become so miserable that they will leave voluntarily, thereby reducing the euro zone to a like-minded core, and lowering risks to Germany’s own monetary and fiscal stability from any pressure to rescue the weak economies. The second hypothesis is that the Germans really think these policies could work. One possibility is the weaker countries would have so big an “internal devaluation” that they would move into large external surpluses with the rest of the world, thereby restoring economic activity. Another is that a combination of radical structural reforms with a fire sale of assets would draw a wave of inward direct investment. That could finance the current-account deficit in the short run, and generate new economic activity in the longer run. Maybe German policymakers believe it will be either harsh adjustment or swift departure. But “moral hazard” would at least be contained and Germany’s exposure capped, whatever the outcome.

I still believe there is a third “hypothesis”.   Germany is willing to move (if hesitantly) from some of these “no” positions, but requires certain assurances and demonstrations of intent.   Will these assurances be forthcoming?   Will it be enough?