Private Debt Relief

The debate over the private debt relief has developed a lot of momentum, with the both the Central Bank and the Department of Finance now seemingly increasing the pressure on banks to provide debt relief.   While there certainly is a case for targeted debt relief, it seems to me that there are a number of confusions in the debate.   I think the following points are worthy of some discussion. 

1.       The distinction between accounting loss recognition and debt relief

This is a point that has previously been emphasised by Greg Connor (see quote here).   The processes of loss recognition for accounting purposes and debt forgiveness are very different.    In part motivated by the Japanese experience, it was recognised early in the crisis that it is critical for banks to recognise losses and then to be properly recapitalised.   Failure to do so can lead to the “zombie banks” phenomenon, whereby effectively undercapitalised banks are unwilling to lend.    This can further be associated with “zombie borrowers”, whereby banks engage in “evergreening of accounts – essentially lending more money to prevent default – so as to avoid having to recognise the losses.  

Through the PCAR process, Irish banks have been forced to recognise losses and to be propertly recapitalised, although concerns about mortgage losses have left lingering doubts about whether the process has gone far enough.   But this process is consistent with banks doing everything possible to maximum the recovery of loans – even loans that they have written down on their books.   Minimising the need for yet further capital injections requires that banks only forgive debts if it actually increases the expected recovery.

2.       The “debt Laffer curve”

I have mentioned the “debt Laffer curve” before, but I think my exposition just caused confusion.   But I still think it is a very useful device for thinking about the case for debt forgiveness.   The basic diagram is here.    The horizontal axis measures the present value of payments to the bank assuming full repayment on a given debt obligation.   The vertical axis measures the expected present value of the repayment.   The “debt Laffer curve” shows the relationship between the present value of the debt obligation and the expected repayment.   The basic case for (mutually advantageous) debt relief comes from the possibility of the curve beginning to slope down beyond a certain point.   This means that debt forgiveness could actually raise the expected value of repayment.   This could happen, for example, if lowering the debt burden means the borrower has stronger incentives to raise their income or to avoid default (where repossession would b e costly for the bank).    Such cases are certainly conceivable, but it is a fairly demanding hurdle.  (I would be very interested in commenters’ views on this.)  

There is, of course, the extra complication of the much discussed moral hazard/strategic default.   If the bank provides relief for people in certain conditions, then there is the potential for a bad “pooling equilibrium” where people have the incentive to be in those conditions.   Colm McCarthy has famously put this in a pithy way:

Since you cannot get blood from a stone, it is desirable to streamline the personal insolvency arrangements so as to recognise this reality.  But no incentives should be created which encourage those who can pay to disguise themselves as stones.

Now it may well be that the government wants the bank to provide debt relief even where the curve is upward sloping but relatively flat.   The relief would have the added advantage that it could help stimulate household spending.   But if this is the policy, then it is better to admit up front that the policy means bigger losses for the bank and, where the bank is State owned, ultimately for the State.   There is a danger that State-owned banks will be forced to follow a range of political objectives, storing up longer term fiscal problems and making harder to gauge the ultimate performance of the banks.   If the government wants broader debt relief, then it is better to provide appropriate subsidies and then let the bank get on with – and be accountable for – maximising value. 

3.        Insolvency rules

One way to make it more likely that the bank has an incentive to forgive debt to prevent outright default is to strengthen the “threat point” of the borrower through more debtor-friendly bankruptcy laws.   Making bankruptcy or other insolvency rules more borrower friendly is likely to reduce the value of the banks.   But I think the focus here should be on the overall design of the regime.   The current regime is archaic and brutal and needs to be reformed.   If moving to a modern regime results in losses, then additional losses for the banks is a bullet to be bitten.

However, much of the discussion in pitched in terms of a trade off between debt and creditor rights – and creditors understandably get little sympathy at the moment.   But it is important not to forget the “instrumental role” of creditor rights in ensuring there is an incentive to provide credit in the first place.   Everyone’s creditworthiness is tied to there being reasonable protection of creditor rights. 

Colm McCarthy:Ireland gets its reward for being EU’s little pet poodle — nothing

Colm McCarthy expresses understandable frustration with the pace of developments in meeting the commitments made on June 29th(see here).   Central to Colm’s criticism is what he sees as a fundamental inconsistency between the government’s claims of success in its crisis-resolution policies and calls for some form of official relief on banking-related debt.

Since the resort to an EU/IMF bailout in November 2010, the Government has pursued a strategy with two central components. The first is that Ireland’s debt is sustainable, since the economy is recovering and budgetary adjustment will be delivered on schedule. Ireland will re-enter the bond market and exit the programme at the end of 2013. The second is the pursuit of relief from a portion of the bank-related debt, on the grounds that it was improperly imposed.

Last week’s events should highlight once again the inconsistency of this strategy. If things are going fine, why is there any need for debt relief? The best case for debt relief (Greece was relieved of €100bn) is inability to pay.

The insistence that things are fine, that budget adjustments are on schedule, three-month Treasury bills can be sold and Ireland will exit the rescue programme next year, is a serviceable domestic political message. But it is also an open invitation to our European ‘partners’ to offer no assistance whatsoever outside the terms already agreed.

A better negotiating platform, and one with at least equal plausibility, is the following: that the debt is not sustainable and will reach 150 per cent of national income; the economy is flat and will remain so; the politics of further retrenchment are getting too difficult and debt relief is inevitable. The Government should quit behaving like the marketing arm of a debt-management agency.

Although I always hesitate to disagree with Colm, I don’t see the government’s strategy as fundamentally inconsistent.  Since peaking at 15.81 percent on July 15, 2011, the yield on the benchmark 2020 bond has followed a strong downward trend to close at 4.53 percent on Friday (Bloomberg).  Assuming a recovery rate of 50 percent in the event of a private-sector default, that the yield on the equivalent German bond represents the risk-free rate and risk-neutral investors, the implied probability of default peaked at 83.8 percent in July 2011 before more than halving to 39.7 percent on today.   

Of course, a default probability of close to 40 percent is still very high.   I think the main reason that the perception of default risk still remains so high relates to the uncertainty surrounding growth prospects.   A poor outcome on growth could make the necessary fiscal adjustments to meet the conditions for official support without a private-debt restructuring politically – and possibly even economically – impossible.   Adverse growth shocks will also do more damage to the ability to meet deficit- and debt-reduction targets the higher is the starting debt ratio.  

Recognising the common interest in a successful return of Ireland to creditworthiness, there is a case for making adjustments to official policies that reinforces the improvements made so far.   One such improvement would be to lengthen the period for paying down ELA and make continued access to that funding more reliable.  By rewarding countries that meet their commitments rather than the opposite, such actions should also help to reduce official-lender concerns about moral hazard. 

I worry that emphasising unsustainability under current conditions would suggest a weaker commitment to meet the conditions required for official support.   Any resulting weakening of perceived creditworthiness could itself undermine growth by raising the spectre of Greek-style chaos.   I believe it is better to emphasise that Ireland fully intends—and expects – to do what is necessary to avoid default, but there are certain factors that it simply can’t control.    Recognising this, there is indeed a common interest in adjusting official support policies to further support a “well-performing adjustment programme.”

Wolfgang Münchau: Relentless Austerity Will Only Deepen Greek Woes

Wolfgang Münchau has an interesting article in today’s FT (see here).   Not surprisingly, he highly critical of official policy towards Greece and pessimistic about the country’s prospects without a change of course.   Central to the argument is that the fiscal adjustment being demanded of Greece is self-defeating: attempts to lower the primary deficit through fiscal adjustments slow the economy so much that the primary deficit actually rises. 

While I agree with Wolfgang’s bottom line, I would put the problem somewhat differently.   Even allowing for two-way feedback between the deficit and GDP, standard analysis shows that, all else equal, changes to the structural primary balance do lower the actual primary balance.   Moreover, this result holds for any size of deficit multiplier.  (See, for example, Equation 4 from Annex B here.) 

But of course all else is not equal.   A big part of what is holding back a Greek recovery is fear of a catastrophe, in which Greece loses official backing and is forced to default and potentially exit the euro.   The tougher the conditions applied to Greece the greater is the fear that it will simply not be able to do what is required for continued support.   This fear acts as a huge drag on the economy, leading spending to contract and limiting any improvement in the deficit. 

Perhaps ironically, a similar phenomenon was nicely captured by Olivier Blanchard in his comment on the original expansionary fiscal contraction paper by Giavazzi and Pagano (see here pp. 111-116).  After considering a version of the basic mechanism discussed by Giavazzi and Pagano, Blanchard notes:

This formalization focuses on the effects of consolidation on the expected level of output; there is another, probably equally important implication of consolidation that this formalization does not capture-the effect of consolidation on uncertainty. Consolidation may be associated, at least after a while, with a substantial decrease in uncertainty, leading to a decrease in precautionary savings, to a decrease in the option value of waiting by consumers to buy durables and by firms to take investment decisions. 

While the mechanisms are similar, I think the situation is quite different for Greece today, with the actions of official creditors key to the restoration of confidence.   Rather than more decisive fiscal adjustment being the route to restore confidence, a better route would seem to be less demanding conditionality for access to official loans – conditions that stand a better chance of being politically acceptable.  This would reduce the pervasive fear that it will all go pear-shaped if the government fails to meet the conditions.   The positive effect of reducing this fear would be to help stop the contraction in Greek economy, and should actually allow a faster improvement in the deficit, ultimately reducing risk to official creditors.   Both sides could gain from a programme with better odds of success. 

Update

It is useful to revisit the arguments above in light of the excellent analysis in the IMF reports linked to by Philip.   The findings in Box 1.1 of the WEO have received most attention this morning.   The key message is that fiscal multipliers appear to have been underestimated.   Given the robustness of the results to a variety of controls, this analysis is broadly convincing.   The arguments and findings in Box 1.3 are also very interesting, showing the adverse affects of uncertainty on growth.  This underlines the cost of the failure to develop crisis-resolution policies that remove the risk of a serious escalations of the crisis in the most vulnerable countries. 

Derek Scally’s Interview with Wolfgang Schäuble

In today’s Irish Times Derek Scally reports on an interesting interview with German Finance Minister, Wolgang Schäuble.   (Edited transcript available here.)     Overall, Mr. Schäuble comes across as thoughtful and strongly committed to finding a way through the crisis that preserves the euro zone.    But the claim that further official assistance in the form of relieving some of the burden of banking-related debt could worsen Irish prospects is not convincing.  

Put yourself in the shoes of a potential investor in Irish debt.   On hearing of a reduced burden on official debt, would you: (a) upgrade your view on the ability of the Irish State to avoid default on private debt based on its improved financial position; or (b) panic because the situation must be worse than previously believed, or else the increased official support would not be forthcoming?   I would think that potential investors are well aware of the objective facts of Ireland’s situation.  One of these facts is the extent of available official assistance.  

Of course, the German government can choose not to support actions aimed at “further improving the sustainability of the well-performing adjustment programme” (July 29th communiqué).   But this argument for withholding such support should be strongly challenged.  

(It is noteworthy that Jörg Asmussen, a member of the Executive Board of the ECB, made a similar argument in his IIEA speech in April – see here.) 

Amortising Bonds and Sovereign Annuities

Details of the today’s sale of “amortising bonds” by the NTMA are available here.   See here for the “information memorandum”.  The NTMA statement announcing the intention to sell the bonds in response to demands following the annoucement of the revised Pensions Board funding standard is here.

The new bonds will facilitate the development of “sovereign annuities”.   While there is no easy answer to the funding crisis in defined-benefit pension schemes, risks placed on pensioners through default risk on sovereign bonds should not be neglected. 

A briefing statement on sovereign annuities from the The Society of Actuaries in Ireland is available here.   Guidance to trustees and providers of sovereign of annuities is available from this Pensions Board link (see Related Documents).  A FAQ on the revised funding standard is available here.

Charles Wyplosz on Italy’s “Bad Equilibrium”

Charles Wyplosz issues a stark warning here – a warning well worth heeding.  

But is he too pessimistic?    The fact is that the ECB has the power to cap bond yields.   With bond yields capped at a reasonably low level – say 4.5 percent – the Italian government should be able to avoid default, even with a formal adjustment programme of structural reforms and fiscal adjustments.   I doubt the programme would have to involve much beyond what the country is already doing.   Mario Draghi has held out the promise – albeit maybe a bit too vaguely – of such support in return for conditionality.   All sides have to move.

Simon Wren-Lewis on conditionality in bond-buying programmes

Simon has an interesting post that challenges arguments against unconditional bond-buying (QE) by the ECB.   He makes a convincing case that such bond-buying for specific countries to avoid a “bad equilibrium” would not violate the ECB’s price stability mandate.   

But I think his analysis misses another key (if implicit) aspect of the ECB’s mandate: in a highly incomplete political union, the ECB must minimise the risk of redistributions between members through its monetary policy (see this earlier post).   Losses on bonds will be shared across the monetary union.   Concerns that monetary union is a vehicle for such redistributions could doom the entire project.   Of course, there is risk of such losses even on normal monetary policy operations.   But this is why these operations take place within a strict risk control framework.   For bond-buying, fiscal conditionality can be viewed as an effort to reduce the risk of losses, and ultimately redistributions between monetary union members.  

Now it could be argued that fiscal conditionality actually increases the risk of losses.   This would be the case if fiscal conditionality is self-defeating — that is, slows the economy so much that the fiscal situation actually deteriorates.   Opinions differ on whether this is the case.   However, if influential members believe that the ECB’s actions would unacceptably increase the risks of losses without conditionality, then the ECB would find it difficult to proceed with bond-buying, and find it particularly difficult to make the strong commitment necessary to keep yields low enough to credibly remove the danger of the bad equilibrium (see here).

The bottom line that redistributive politics within the monetary union mean that the kind of strong commitment needed to keep yields low is near impossible without conditionality.   The choice may be for the ECB to act with conditionality or not to act at all. 

Measured Macroeconomic Performance

In a series of informative comments across recent threads, Michael Hennigan has raised important questions relating to the reliability of the recorded growth in key macroeconomic aggregates, and also the employment performance of internationally traded sector in general and the foreign-sector in particular. (See here for a useful summary from his Finfacts website).  Although Michael watches these figures much more closely than I do, and so I hesitate to contradict him, I find it hard to share some of his concerns.  

First a point of agreement:  At roughly 100 percent of GDP, Irish exports are strongly influenced by the activities of multinationals operating in Ireland, and the numbers tell us little about value added and incomes in Ireland.   Where I have difficulty following Michael is in his concerns about the reliability of Irish GNP and GDP figures.   GNP excludes the profits of multinationals (and not just repatriated profits), and so should be immune from concerns over tax-driven transfer pricing.    GDP excludes imports (including intermediate imports and royalties).    Michael says the Irish exports are overstated by one third.   If he has a chance, he might explain this in more detail, and also how he sees it affecting measured GNP and GDP given the exclusions just noted. 

Michael also notes that employment in the foreign-owned sector has fallen from 166,000 in 2000 to 144,000 in 2011.   This fall is certainly very regrettable.   But it occurred during a massive bubble-driven, structural mal-adjustment of the economy.   Given the extent to which the bubble affected the allocation of resources, I am surprised the damage done to the traded sector was not much greater.  Part of the answer would appear to be the highly elastic labour supply response – notably through immigration – which allowed the construction and other non-internationally traded sectors to expand, while limiting the damage to the traded sector. 

I do share Michael’s concern over risks around the projected return to robust growth after 2013.  But my main concern is a prolonged “balance-sheet recession”—and not just in Ireland.    While Michael’s description of the nature of much multinational activity in Ireland seems accurate, I find it hard to share his concerns about its implications for measured Irish growth performance.   I am ready to be corrected. 

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.

Stumbling into disaster

I am just back from a conference in Berlin that was attended by finance officials from a number of euro zone countries.   I must admit that what I heard left me with an increased sense of foreboding on the future of the euro zone.     To no great surprise, officials from stronger countries made it clear their governments are willing to pay a significant price to save the euro zone – but not any price.   What worries me most is the emphasis on restoring “market discipline” given concerns for moral hazard, including the continued threat of debt restructuring.   (The sentiment behind Deauville has not gone away.)  While I have no trouble in understanding this position from likely net contributors under enhanced risk sharing arrangements, it is a recipe for Italy and Spain being driven from the bond markets.   The concern of stronger countries for their own creditworthiness under guarantee arrangements was also emphasised – and, again, is understandable.  

As has been pointed out before, the main message from “second-generation” currency crisis models is very relevant.    Concerns about the willingness of policy makers to bear the costs of protecting a currency peg — or avoiding default — leads to increased expectations of those events, raising the costs of avoiding them still further.   It is all too easy to fall into a self-fulfilling, bad-expectations equilibrium. 

So what is the way out?   Stronger countries need to lay out what institutional arrangements they require to support enhanced risk-sharing arrangements, including some substantial form of euro bonds.   For the medium-term, credible institutional discipline must replace market discipline.   The present mixed approach is not working.   In deciding whether to accede to arrangements that would significantly diminish fiscal/banking sovereignty, all countries must recognise the likely path under the present course.   It might be a bridge too far, but at least we should not stumble into disaster. 

Let’s not get carried away

While the euro zone leaders’ summit certainly exceeded expectations, the shift from dire pessimism to elation in the Irish press reaction over the last few days seems overdone.    The big question across numerous articles seems to be how much of the €63 billion put into the banks will now be mutualised.   Unfortunately, I don’t see anything in the post-summit statement that leads me to revise a view that the chances of other European countries absorbing already crystallised losses in the Irish banks are approaching zero – the “similar treatment” statement notwithstanding.   More positively, the chances of beneficially refinancing the promissory notes/ELA arrangement looks to have  increased, which (depending on the details) could lead to a large NPV benefit, and thus significantly reduce the burden of banking-related debt.    While this might partly explain the fall in bond yields, my guess is that the majority of the fall reflects a decline in the chances of a major euro zone crisis following financing difficulties in Italy and Spain.    Excessively hyping what has been achieved runs the risk of later disappointment, undermining support for unavoidable adjustment efforts. 

Another worry is that the triumphalism on display following the summit runs the risk complicating German politics on risk sharing.   Thus far, the German government has moved incrementally, slowly bringing a sceptical electorate along with them.   The perception that “Merkel blinked” could lead to a backlash.  

So, yes, Friday morning brought some very welcome news.    But there remains a hard slog ahead. 

Ronan McCrea: EU reforms call for new approach to referendums

Ronan McCrea has an op-ed in today’s Irish Times that is worth debating.    His proposal:

If we are to avoid an endless series of referendums in the coming years, we will have to give the Government a degree of authority to agree to treaty changes that have not yet been agreed.

This would require a more general amendment to the Constitution, giving the State the right to participate in a fiscal and banking union. Such an approach would allow the State to sign up to the numerous amendments that are likely in the coming years if the euro is to be saved.

Given the seriousness of the implications of fiscal union for our political system, it would be desirable that there would be a further referendum at the end of the process. Once a fiscal and banking union is fully in place, then voters could decide by referendum whether they would like to be in or out of such an arrangement.

Often lost in the recent referendum debate was recognition that developing the necessary fiscal and banking integration to underpin the euro is a two-way process.   The countries most likely to be net contributors under strengthened risk-sharing arrangements will be reluctant to agree to those arrangements without credible assurances of mutual discipline.   Given the necessity of these arrangements, it is not enough to lambast Germany for not being willing to move fast enough.   The extent of the political challenge means that there is responsibility on all countries to make the necessary changes feasible.

Willem Buiter: Race to save the euro will follow “Grexit”

Willem Buiter provides another incisive analysis of the euro zone crisis is this FT article.

From the article:

The endgame for the euro area, if the political will to keep it alive is strong enough, is likely to be a 16-member area, with banking union and the minimal fiscal Europe necessary to operate a monetary union when there is no full fiscal union.

Minimal fiscal Europe will consist of a larger European Stability Mechanism, the permanent liquidity fund, and a sovereign debt restructuring mechanism (SDRM). The ESM will be given eligible counterparty status for repurchase agreements with the eurosystem, subject to joint and several guarantees by the euro area member states. There will be some ex-post mutualisation of sovereign debt. Sovereign debt restructuring through the SDRM will recur.

One question is whether vulnerable euro zone countries could ever hope to regain robust creditworthiness with the SDRM hanging over them.   Given the likely effects of threatened “bail ins”, it seems too early to give up on more ambitious efforts for ex-ante debt mutualisation along the lines of the German “wise men” proposal.  (Gavyn Davies provides a useful analysis of the proposal here.   This Bruegel blog post considers the less ambitious alternative of “eurobills”, which could be a stepping stone to more ambitious “eurobonds”.)

The European Redemption Fund Proposal

The proposal for a Debt Redemption Fund made by the German Council of Economic Experts seems to be gaining a bit more traction (see here).   This working paper from February provides a useful overview.   Given that this is the only “eurobonds” proposal with anything approaching momentum, it is worth debating its merits. 

Some of the basic elements:

·         Countries would be able to finance an amount of debt (as a share of GDP) equal to the difference between current levels and 60 percent of GDP through the fund.   This would occur as new funding needs (deficits/redemptions) arise

·         The fund would have joint and several guarantees

·         Repayments would be a constant share of GDP, equal to the ERF interest rate plus one percent divided by initial GDP.   The repayment schedule is designed to fully repay fund borrowings in 20 to 25 years

·         Countries would have to commit to reduce their total debt to below 60 percent of GDP.   Longer term, it doesn’t appear that there would be additional commitments beyond the revised Stability and Growth Pact and Fiscal Compact.   However, during the “roll-in” phase, countries would have EFSF-style adjustment programmes

·         Would only apply for current programme countries after they had exited their programmes. 

Continue reading “The European Redemption Fund Proposal”

Karl Whelan on the Burden of Bank Debt

Karl Whelan has a very useful post on options relating to reducing the burden of banking-related debt (see here).   Of particular interest is his comparison of the present discounted cost of the current promissory notes/ELA arrangement and a low-interest (3 percent) long-term (30-year) financing deal with the ESM to immediately payoff the ELA.   This calculation shows that that ESM alternative has a lower NPV by a wide margin.  

We could perhaps quibble with some of the assumptions used in the calculation.   Karl assumes the ECB’s main refinancing rate rises to 4.5 percent by 2016, which would require a strong euro zone recovery (see Table 7 here).   Also, in a world where official financing remains available as an option over the longer term, the assumed discount rate of 7 percent (based on current secondary-market bond yields) could be considered high.   (I am also not sure from the calculations if Karl is allowing for Irish Central Bank profits on outstanding ELA.)  But Karl’s basic conclusion seems robust to reasonable relaxations of these assumptions.    

Karl notes that I am “neutral” with regard to whether the long-term refinancing via the ESM would be a good deal, waiting to see the details.   Based on his numbers, I am happy to agree that a 30-year deal at 3 percent is likely to result in a substantial reduction in the burden of this debt.

Seamus Coffey on Resolving the Euro Zone Banking Crisis

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. 

The measured rise in Irish inequality

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. 

A better deal on bank debt: What is achievable?

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. 

Does it have to be “close to, but below two percent”?

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.

Boone, Johnson and Wolf on the euro zone’s future

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?

Compact Logic

After wavering for some time, Deputy Shane Ross has now publicly taken a No position on the Treaty. (See Sunday Independent article here.)   His position is that he is withholding judgement until he sees later growth-focused elements, and takes it that there would be another opportunity to vote on the complete package later. 

While this is a coherent position, I think it is worthwhile to stand back and recall the genesis of the fiscal compact.   The euro zone crisis was spinning out of control late last year, with runs on the sovereign bonds of Italy and Spain.  (The crisis has flared up again recently with the renewed uncertainties in Greece.)   It became ever clearer that the euro zone might not survive unless stronger mutual insurance mechanisms were developed.   Understandably enough, the euro zone countries most at risk of having to make positive net transfers under such mechanisms wanted some degree of assurance that all euro zone countries would follow reasonably disciplined policies, both to limit the expected value of the contingent liability and to minimise inevitable moral hazard.   Politicians in stronger countries also needed a degree of political cover in order to convince their electorates to take on large risks.  

For the most part, it was evident that stronger commitments to mutual discipline would have to lead that strengthening of the mutual insurance mechanisms, but the logic was clear.   In the event, the actual fiscal compact did not go much beyond what countries had already signed up to under the revised Stability and Growth Pact, but it did attempt to strengthen domestic ownership by introducing domestic enforcement mechanisms for the already existing structural balance rule.   Recent events in Spain have brought the possibility of more centralised bank resolution, deposit insurance and supervision onto the agenda as part of this process. 

An often heard complaint in the debate that the commitment to develop these mutual insurance (and related growth) measures are too vague – hence Deputy Ross’s position.    But it is interesting that where the linkage is made explicit – i.e. access to a scaled up ESM – it is considered a “blackmail” clause.  

Not surprisingly, the Treaty debate has ranged widely – the impacts of austerity measures, the implications for post-2015 fiscal adjustment of the existing SGP rules, the nature of additional commitments made under the Treaty, access to alternative sources funding if the Treaty is rejected, etc.   An unintended positive spinoff is that voters are now much better informed on fiscal issues – even if sick to the teeth from hearing about them.   But in the few days remaining before the vote, and with the euro zone again in turmoil, it is important to bring focus back to the core purpose of the compact. 

DeLong and Summers and Self-Financing Fiscal Expansion (very wonkish)

Advance warning: This post will only be of interest to those who have read the DeLong and Summers paper.

As has been referenced on this blog a number of times, the recent paper by Brad DeLong and Larry Summers has had a significant impact on the debate over optimal fiscal adjustment in a depressed economy.    Although the authors themselves note that the balance of arguments may be quite different in a non-creditworthy economy, the paper is still important to our debate (see also here and here).   

The key innovation in the paper is to incorporate the fiscal implications of potential “hysteresis effects.”  Put simply, these effects refer to long-lasting effects on future output – and thus on the future fiscal position – of fiscal adjustment measures today that reduce today’s output.   For example, the loss of a job due to weaker growth this year could have long-lasting fiscal implications if it makes it harder for the person losing their job to gain employment in the future. 

A striking conclusion in the paper is that, under what appear to be a relatively undemanding set of conditions, an expansion of government spending (or alternatively not engaging in some planned expenditure cut) could be self-financing from a long-term fiscal perspective.    Put another way, fiscal expansion could bring about improvement rather than disimprovement in a country’s underlying creditworthiness.  Thus, fiscal adjustment could be self-defeating from a creditworthiness perspective.   Given the influence of their argument, it is important to look closely at the assumptions that underlie this result.  Continue reading “DeLong and Summers and Self-Financing Fiscal Expansion (very wonkish)”

Gavin Barrett Responds to Vincent Browne

A Guest Post By Gavin Barrett

While I am second to none in my admiration of Vincent Browne for his willingness to engage with the legal issues raised by the Fiscal Treaty, I would have difficulties with some of the assertions made by him in his article in the Irish Times today.

1)      I am unable to see how the Pringle case (or any other case) can be the source of a legal threat to the Fiscal Treaty’s validity (as opposed to the ESM Treaty’s). The Fiscal Treaty is a normal intergovernmental treaty which the member states are perfectly entitled to agree with each other in international law.

2)      To my mind, the European Stability Mechanism Treaty clearly does not violate Article 3 TFEU. Nor does the Fiscal Treaty.  (Article 3 TFEU, as Vincent Browne correctly points out, confers exclusive competence on member states whose currency is the euro). The ESM Treaty has nothing to do with monetary policy. It sets up a permanent bailout fund to lend to member states in distress. The Fiscal Treaty also has nothing to do with monetary policy. As its name suggests, it has to do with fiscal (i.e., taxation and expenditure) policy.

3)      It is very far from clear that the Article 136 TFEU amendment process gives an opportunity to member states to veto the setting up of the ESM. It may be argued that it does, but it is not something I would bet the house on, much less the future of the Irish economy, which is what the ‘no’ side appear to want to do. The Referendum Commission does not support the view that there is a veto. Nor do the member states themselves, which will establish the ESM in July 2012 without Article 136 being in force. 

All going well, Article 136 TFEU should however be amended shortly afterwards by 1 January 2013. (Ireland, incidentally, has very little interest in vetoing this amendment, since it will put the legal basis of the ESM Treaty beyond any possible doubt. That is a good thing, since it looks increasingly likely Ireland will need to turn to the ESM for a second bailout in 2014.)

4)      I am unaware of any reason for questioning the use of the so-called Article 48(6) simplified revision procedure to effect the amendment to Article 136 TFEU.

5)       I am not aware of fundamental changes being planned for the EU’s structure which bypass procedures suitable for such change. The only one question mark that might be posed is in going ahead with the ESM Treaty without the Article 136 TFEU amendment. However, even if one took the view that the ESM Treaty should be supported by the Article 136 TFEU amendment, the latter amendment should follow its establishment within six months, then removing whatever doubt may be felt to exist in this regard.

Martin Wolf and the new “impossible trinity”

Martin Wolf provides a cogent if sobering analysis of the euro zone crisis (FT article here; Irish Times article here).    I previously discussed the “impossible trinity” facing euro zone in posts here and here.   The euro is facing an existential threat; there are political limits to the possibility of a transfer union (including limits on potential net transfers under strengthened euro zone mutual insurance mechanisms); and the ECB does not consider a higher inflation/nominal GDP growth target as consistent with its price stability mandate. 

Martin Wolf describes the dilemma thus:

If dismantling the euro is out of the question, true federal finance is unavailable and mutual solidarity will remain limited, what is left? The answer is faster adjustment, to bring economies back to health. Indeed, that would be essential even if stronger solidarity were available. The euro zone must not turn the weaker economies of today into depressed regions, permanently supported by transfers, a policy that has blighted the south of Italy.

So how is faster adjustment to be achieved? The answer is through a buoyant euro zone economy and higher wage growth and inflation in core economies than in the enfeebled periphery. Moreover, the required growth strategy is definitely not just a matter of policies for supply.

According to forecasts from the International Monetary Fund, euro zone nominal gross domestic product will rise by a mere 20 per cent between 2008 and 2017. In the latter year, it will be 16 per cent lower than if it had continued to grow at the rate of 4 per cent achieved between 1999 and 2008 (consistent with 2 per cent real growth and 2 per cent inflation).

For the economies under stress, such feeble growth is a disaster: it means that the euro zone as a whole tends to reinforce, rather than offset, their credit contractions and fiscal stringency. They can blame the universal adoption of fiscal stringency and the policies of the European Central Bank, which let the money supply stagnate.

Something may give, and it is potentially disastrous if it is the euro.   The possibility of higher nominal growth targets needs to be part of the debate. 

On strengthening the mutual insurance mechanisms, the discussion in our Treaty referendum debate of the legal mechanisms to stop the ESM going forward borders on the surreal.   The purpose of the fiscal compact is to provide an added degree of assurance that euro zone members will pursue reasonably disciplined policies.   The idea is to give other members sufficient confidence (and a degree of political cover) to allow the mutual insurance mechanisms – probably eventually including some form of euro bonds – to develop.