Author: John McHale

Gavyn Davies has a useful piece in today’s FT highlighting the potential inter-country distributional consequences of ECB actions in support of particular countries (see here).   These consequences are critical to understanding the economics and politics of ECB interventions.   A few key paragraphs:

The implication of this analysis is that the ECB has more than enough “capital” to underwrite the peripheral bond markets, without this being inflationary in the long run. In a single nation state, it would probably prove irresistible to bring forward some of this capital from the future into the present, and then use it to purchase government bonds to resolve the crisis. In countries like the US and the UK, the national treasury could, in extremis, simply command the central bank to do this, which is why independent nation states typically cannot be forced to default on their domestic currency debt (although they might choose to do so by inflation).

The situation of the ECB is different for the now-familiar reason that the institution is the central bank of many nation states, which care very much about the distribution of income and wealth between themselves. The use of the central bank’s non-inflationary capital does not get round this fundamental issue. Since the ECB is owned by all of its members in proportion to their share of eurozone GDP, the future seigniorage of the ECB is similarly owned by all of its members.

If the ECB board chooses to use its notional capital today by buying Italian bonds at subsidised rates, it is in effect triggering a transfer of resources to Italy, away from other members, most notably Germany. This could emerge in the form of ECB losses which might need to be to be recapitalised by member states after an Italian default. Or it might emerge as a reduced flow of future profits from the ECB to nations like Germany. In any event, there would be an implied transfer of resources from Germany to Italy, which is precisely what the German government has opposed implacably.

Drawing on a recent paper by Nouriel Roubini, Martin Wolf lays out the options facing the euro zone with depressing clarity.  (The Roubini paper is accessible here after an easy sign up for a trial subscription.)

Mr Roubini discusses four options for addressing these stock and flow challenges simultaneously: first, restoration of growth and competitiveness through aggressive monetary easing, a weaker euro and stimulatory policies in the core, while the periphery undertakes austerity and reform; second, a deflationary adjustment in the periphery alone, together with structural reforms, to force down nominal wages; third, permanent financing by the core of an uncompetitive periphery; and, fourth, widespread debt restructuring and partial break-up of the eurozone. The first could achieve adjustment, without much default. The second would fail to achieve flow adjustment in time and so is likely to morph into the fourth. The third would avoid both stock and flow adjustment in the periphery, but threaten insolvency in the core. The fourth would simply be the end.

While each of the options brings horrendous challenges, I think that there is fairly widespread agreement among economists that the first offers the best route to save the euro zone.   The problem, of course, is the stonger members are wary, fearing inflation, a large contingent liability from their support of weaker members and severe moral hazard. 

A modest suggestion/question:  Should the government reprioritise its diplomatic efforts away from debt relief to work with like-minded countries to offer the strong countries credible mechanisms for tighter controls over fiscal policy as a quid pro quo for the stimulus components of Option 1?  

Of course, efforts to put in place such controls are well advanced through the Euro Pact Plus.   But these controls are seen as something being imposed on weaker countries, undermining the belief in Germany and other stronger countries that they will actually be respected.   

Might a more more active embrace of the controls — but also making clear that the current restrictive monetary and fiscal policies in the core put the survival of the euro zone at unnecessasry risk — pay greater dividends?

John McManus gives one of the best treatments I have seen of the (tragic) choices at the heart of the euro zone crisis: see here.

I am often accused of being too optimistic about the prospects for the Irish economy.    It is true I believe that if we hold our nerve with the adjustment (more on which below), and there isn’t a major deterioration in the external environment, we can get through this crisis.   But my views on the appropriate strategy for getting through the crisis are at least as much determined by a fundamental pessimism about the financing vulnerabilities facing the Irish State. 

It may be worthwhile to first summarise what I see as the crisis resolution strategy Ireland is pursuing.   It can be summed up as adjustment with financing.    I don’t think anyone disagrees that we need to make significant post-bubble adjustments: fiscal adjustments to put our debt on a sustainable path; banking adjustment to shrink the banking sector to a level consistent with feasible financing; and real adjustment to move resources from sectors with little growth potential (notably construction) to sectors with better opportunities.   

Although the nature of the post-bubble economy is such that we have no choice to make these adjustments, to limit the damage from austerity and bank deleveraging to living standards it is important to make these adjustments as gradually as is feasible.  

But this requires financing: financing for both the large budget deficit, and also for the banks given the insufficient availability of deposits and term funding.    Since we cannot raise sufficient financing in the markets, we have been forced to rely on official sources.    

(In determining the appropriate adjustment speed, we should also not forget that what we borrow now must be paid back with interest – much of it by our children who will also be asked to bear the costs of an ageing population.   Deficit reduction today is not just a question of imposing hardship or not, but also how the burdens will be shared across generations.) 

A central problem is that the future availability of financing is uncertain in today’s volatile international environment.    This reality forces faster adjustment than would otherwise be optimal all else considered.    Getting our deficit and bank funding gap down gives us the best chance of regaining our market creditworthiness.    These efforts also give us the best chance of retaining the official funding that is necessary to allow us to pursue a reasonably gradual adjustment path.   Moreover, a critical element of regaining market funding is that potential future lenders believe that a credible official lender of last resort is in place to give them confidence they will get their money back.  

It is important not to lose sight of what a sudden stop of both market and official funding would mean: it is hard to see how it could not result in massive austerity as we have to close (at least) the primary budget deficit immediately and a likely collapse of the banking system.   I think those who make simple statements about being pro or anti austerity fundamentally underestimate the vulnerability of our situation.   Of course, reasonable people can disagree about the appropriate speed of the adjustment given these vulnerabilities, but it would be good to see a more appreciation in the debate about what is at stake.   

Similarly, I find it hard to understand how people can make such strong statements about the desirability of not repaying the remaining unguaranteed senior bonds without showing an awareness of how close we came to a full scale bank run earlier this year.   While the bank recapitalisation, deleveraging and liability guarantees are components of the strategy to stabilise the funding situation of the banks, the most critical element is the perception of the ECB/CBI willingness to act as a reliable lender of last resort.    Do we really want to reopen depositor doubts about whether the ECB will support Irish banks?   Indeed, I see the main function of the recapitalisation, deleveraging and guarantees as being the price that must be paid for the ECB/CBI to stand ready to play the necessary lender of last resort role.   We should not let (mostly misplaced) anger at the official funders blind us to the vulnerabilities of our situation. 

Note: I had not seen Karl’s post before writing this one, so it is not meant as a response.   Since the two posts cover somewhat different ground I hope they are complementary. 

The argument is increasingly heard that if Greece is allowed a write-down on its debts then Ireland should be allowed a similar treatment.   Unfortunately, a number of different things seem to get jumbled together in the discussion: the costs and benefits of default on State debt; the costs and benefits of default on senior bonds in the former Anglo and INBS; and the costs and benefits of restructuring the promissory notes.   I don’t pretend to have all the answers, but it seems worthwhile to try to disentangle the different elements. 

(1) Implications of a Greek write-down for the possibilities of an Irish write-down

There is almost universal agreement that Greece’s debt is unsustainable.   Largely against the will of the Greek government, the EU/IMF funders are demanding burden sharing with private sovereign bondholders.   This is unlikely to ease the austerity burden being imposed on Greece.   The immediate benefits will go the official funders in the form of reduced loans that they have to make to Greece. 

So could Ireland follow the same path?   While we are certainly not out of the woods in terms of debt sustainability, the situation here is quite different.   The debt to GDP ratio is projected to peak at about 118 percent of GDP in 2013.   Irish bond 9-year bond yields have fallen from a peak of around 14 percent to about 8 percent now – still far too high to return to the markets but reflecting increasing confidence that Ireland will avoid default despite the chaos in the European crisis-resolution effort.   Whether or not you believe that Ireland’s debt is sustainable, a move by Ireland to default on its sovereign debt is likely to be badly received by the official funders.   There is no guarantee that official support would continue to be forthcoming.  Loss of that funding would require the deficit to be closed cold turkey, with the austerity having devastating effects on living standards and the economy.  Even it official funding continued, it is highly unlikely that the required austerity measures would be lessened.   My conclusion is that it is hard to see a short- to medium-term gain from defaulting, with huge downside risks.

Longer-term, a default would obviously enough lower the amount of money we have to pay back.   Against this would have to be weighed the cost of the loss of the asset of creditworthiness/reputation.   Defaults can sometimes be viewed as “forgivable” if undertaken (or forced) as a last resort.   The reason is that they don’t reveal that much about the country’s underlying willingness to honour its debts.   A default by a country that can pay is quite different, and would involve a huge reputational loss for a country that begins with a strong reputation.   Creditworthiness for a country with a large debt, a volatile economy and a large dependence on inward private investment is extremely valuable.   I find it hard to see how a cost-benefit analysis would support trying to voluntarily follow a Greek default precedent.