Hasierarako, ikus EBZ Bill Mitchell-en arabera (1)
Segida
ECB confirms monetary policy has run its course – Part 2
(http://bilbo.economicoutlook.net/blog/?p=43183)
(…) In Part 2, I am focusing on the decision to introduce a two-tiered deposit rate on excess reserves, which is designed to reduce the costs of the penalty arising from the negative deposit rate regime that the ECB has had in place since June 2014. But the most important aspect of the ECB decision was not the monetary policy changes, which will have relatively minor impacts on the real Eurozone economy. The telling part of the whole episode was Mario Draghi’s comments on fiscal dominance. We are entering a new era where the neoliberal obsession with so-called monetary policy reliance is becoming increasingly discredited and exposed by the evidence base. Fiscal dominance is approaching. And the only body of work that has consistently argued for this approach to macroeconomic policy making has been Modern Monetary Theory (MMT) despite what the mainstream economists who are now starting to realise their reputations are in tatters might say.
(i) Gordailuko tasa negatiboak negatiboagoak bilakatzen ari dira
Negative deposit rates go further negative
In its latest decision – spelt out in the Press Release cited in the Introduction, the ECB also decided to :
(a) Set the interest rate “at the level of the average rate applied in the Eurosystem’s main refinancing operations over the life of the respective TLTRO”.
This rate is currently set at zero.
(b) If a bank lends over a benchmark “the rate … will be lower” and “be as low as the average interest rate on the deposit facility prevailing over the life of the operation”.
This rate is now -0.50 per cent.
Overall, even though this is providing the banks with cheaper credit than before, the fact remains that the rather weak credit growth in the Eurozone is driven by the lack of demand from credit worthy borrowers rather than the supply cost of finance.
With weak growth and the ever-present danger of reversion back into recession, it is little wonder that demand for investment loans remains subdued.
The ECB explained the logic of its negative interest rate in this statement (June 12, 2014) – The ECB`s negative interest rate.
The ECB wants monetary policy to be ‘accommodative’ yet, the banks are motivated to pass the cost of the excess reserve penalties onto their borrowers which works against the intent of the policy.
For the German media, the meaning of the ECB’s monetary gymnastics is clear.
Mario Draghi was asked at his press conference to comment on the claims by:
… the CEO of the Deutsche Bank recently said at a conference that if the ECB is continuing this type of monetary policy it may lead or will lead to a destabilisation or a collapse of the financial system
The popular press in Germany is clearly running a campaign against the ECB.
This graphic appeared in the conservative daily German newspaper Bild-Zeitung and depicts ECB boss Mario Draghi as a blood-(saving)-sucking monster preying on the hard efforts by Germans to save.
The Bild story (September 12, 2019) carried the headline “So Draghila sucks our accounts empty. During his tenure we have lost billions”.
Choice.
The story said that Draghi was costing German savers billions in lost euros and his “monetary madness” was “devastating”.
Immediately following this rather scandalous depiction of Mario Draghi, Bundesbank boss, Jens Weidmann, gave an interview to Bild – Ist unser Geld in Gefahr? (September 13, 2019) – or “Is our money in danger?”.
The link is to the English translation provided by the Deutsche Bundesbank. Their translated version (September 14, 2019) carries the heading “Weidmann: ECB Governing Council has gone too far”. I will return to his assessment a bit later.
But the fact he gave an interview to the Bild-Zeitung soon after they had displayed Mario Draghi in that light tells you a lot about the German mentality in this respect.
Anybody else would avoid dealing with a rag like Bild-Zeitung for displaying Draghi as Dracula. Especially when, as you will see later, the German banks will be the largest beneficiaries of the changes the ECB announced last week.
The Financial Times article (September 14, 2019) – There’s a German word for negative rates – said that there is:
… a widespread perception across Germany that the ECB is penalising savers through its monetary policy … former finance minister Wolfgang Schäuble blamed it for 50 per cent of the rise of the anti-European Alternativ for Deutschland party.
The President of the De Nederlandsche Bank, Klaus Knot also joined the chorus.
In an official DNB Press Release (September 13, 2019) – Klaas Knot comments on ECB policy measures – criticised the ECB’s policy decisions, claiming:
This broad package of measures, in particular restarting the APP, is disproportionate to the present economic conditions, and there are sound reasons to doubt its effectiveness.
He claimed that there was no need for any further stimulus as the “euro area economy is running at full capacity”. More on that claim later.
But the idea they are fermenting that interest rates should be increased soon and that the Euro economy is at full employment is an outrageous insult to the millions who remain unemployed!
This view was endorsed by the Austrian central bank governor and some other governing board members.
Mario Draghi responded to the question by acknowledging “the negative side effects on the people especially in those parts of the eurozone where the negative rates are being passed to corporate … depositors”.
He went on:
… the banks would like to have positive rates, unquestionably …
But he denied that the “negative rates would cause the collapse of the financial system because before getting there one has to look at other things of our banks.”
He said that the “certain structural weaknesses in the banking sector” in the Europe were not much to do with the negative deposit rates.
While his language was typically cautious, his statement on this was really reflecting on the poor management of the commercial banks, that have grown used to taking positions of excessive risk to grab profits out of the system, and, then, when the risk impacts and the strategies backfire, they put their hands out for public sector bailouts.
Privatise the gains, socialise the losses – the neoliberal way!
(ii) Bi mailatako gordailuko fokapena
The two-tiered deposit approach
Accompanying the decision to go further into the negative range for the deposit rate, the ECB determined that:
In order to support the bank-based transmission of monetary policy, a two-tier system for reserve remuneration will be introduced, in which part of banks’ holdings of excess liquidity will be exempt from the negative deposit facility rate.
Both Japan and Switzerland have introduced tiered systems for bank reserves, although their particular schemes differ in design.
The bottom line is that once the deposit rate is negative, banks are then punished for holding excess reserves. The deposit rate has dropped from -0.4 per cent to -0.5 per cent.
The following graph shows the evolution of excess reserves in the Eurosystem from its inception to July 2019. The early spike relates to the LTRO scheme and the subsequent decline was due to the fact that as financial stability improved the banks took advantage of ECB rule changes to pay back the refinancing liabilities ahead of schedule.
You can read about that in the ECB – Ad hoc communications.
The subsequent positive spike relates more to the continued ECB QE bond purchases.
One of the features of Modern Monetary Theory (MMT) that is neglected by mainstream macroeconomics and monetary theory is the concept of bank reserves.
The mainstream treatment of bank reserves is mostly wrong.
Students learn that reserves are necessary for banks before they can make loans, as if they make the loans from the reserves – both propositions are not applicable to a real-world monetary system.
It is crucial to understand why, because that understanding allows us to correctly, in this case, appraise the ECB’s decision in relation to excess reserves.
Banks do not loan out reserves to retail customers.
Rather, bank reserves are an integral part of the ‘payments system’, where commercial banks use their exclusive accounts with their relevant central bank to settle transactions between themselves.
So, on any particular day, a multitude of transactions occur that have claims on funds between banks (for example, Bank A customer deposits a cheque from Bank B Customer which has to be cleared).
In some jurisdictions, the payments system has been referred to as the ‘clearing house’, harking back to when there were a lot of paper cheques that had to be reconciled each day.
Banks try to assess their daily reserve requirements but also, typically, will not choose to hold in excess of those clearing requirements because the reserves usually return less than a commercial return.
As we know, the deposit rate in the Eurozone, for example, is now -0.50 per cent. A ‘penalty’ rate on excess reserves.
Banks reserves also play a crucial role in the operations of central bank monetary policy. Reserves are provided exclusively by the central bank although that does not mean that the central bank can reasonably control their level.
I won’t go into the detail of how reserve accounts have broadened in some jurisdictions (for example, Britain) to include non-bank financial institutions. That sort of detail is unnecessary here.
Central banks use reserves management as a means of implementing their monetary policy – that is, maintaining a particular short-term policy interest rate.
So, typically, if there are excess reserves, which would otherwise drive the short-term rate down below the current policy rate, because the competitive process whereby banks try to loan those reserves to each other drives the rate down, the central bank would sell interest-bearing securities and drain the reserves.
And vice versa in the case of a shortage of reserves.
In the current post-GFC environment, central banks just pay a support rate on the reserves and this quells any incentive of banks to try to rid themselves of excess holdings.
It eliminates any need for the central bank to engage in traditional open-market operations (selling bonds and draining excess reserves or vice versa).
In this case, there is little difference between a reserve balance and a holding of short-term government debt – both are highly liquid (can be exchanged for cash at will) and both deliver some a return on holding (usually). The only real difference is the ‘name’ on the central bank account that records their existence.
The point to be clear about is that when MMT economists talk about the government currency-issuing capacity (which allows us to conclude that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency), we are not talking about ‘money’ in the way people usually think about that term.
We are, instead, talking about the monopoly supply of bank reserves from the central bank and actual cash.
Many critics, who haven’t read our work closely enough, but conclude they are experts nonetheless, miss this point, when they claim that MMT is wrong in asserting that the government is the sole source of currency because banks creates deposits whenever they create loans.
The latter point is true – loans create deposits – which bears on the mistakes that mainstream monetary theory makes when it thinks deposits are needed before loans can be made.
But while banks can create ‘money’ in that broad sense, it is not the same ‘thing’ as currency creation.
Further, fiscal deficits push reserves up on a daily basis. This process helps us to understand why the claims that government borrowing pushes up interest rates and crowds out private investment is contrary to the reality.
If the central bank does nothing, then the pressure on interest rates from on-going deficits is downwards not upwards. Of course, the central bank might construe that the fiscal deficits are likely to be inflationary and push up rates through policy decisions.
But this is an entirely different argument than that based on ‘classical’ loanable funds reasoning, which Keynes negated convincingly in the 1930s, but which has resurfaced in this neoliberal era.
The other point to understand is that QE programs also increase bank reserves and contributing to the growing excess reserves in the system.
In this way, as we will see, there is a tension between a negative deposit rate policy stance, which penalises excess reserves, and QE which add to the excess.
The decision to introduce tiering reflects the fact that the various policy initiatives are not internally consistent.
The reduction in the deposit rate provides an incentive for banks to reduce their excess reserves.
But QE does the opposite because it works against the banks’ desire to run down reserves. In a QE system, the volume of reserves in the system are driven by the central bank – they are what we call supply-determined by the extent of the bond-buying program.
Without the QE system, the level of reserves in the system are at the call of the commercial banks with the central bank standing ready to supply the level demanded.
And so at present, if there are excess reserves in the banking system, the banks themselves cannot eliminate that, even though and individual bank can reduce their excess by pushing it onto another bank.
Do some arithmetic:
1. As at July 2019, the ECB reported that Excess reserves for credit institutions that are subject to minimum reserve requirements stood at 1,204,271 million euros.
2. The current penalty on those credit institutions for holding those reserves at the ECB would be 4,817 million euros over 12 months.
3. The new penalty (-0.05) will rise to 6,021 million euros.
4. Then add in the next round of QE (APP) and that penalty rises as more reserves are forced into the system by the ECB.
The tiering initiative is designed to reduce the costs on the banks and those with bank deposits. It means that the reintroduction of QE can go hand-in-hand with further movements into the red for the deposit rate without increasing the costs on the banks.
How?
The ECB Press Release (September 12, 2019) – ECB introduces two-tier system for remunerating excess liquidity holdings – noted that:
1. “All credit institutions subject to minimum reserve requirements … will be eligible for the two-tier system”.
2. “The two-tier system will apply to excess liquidity held in current accounts with the Eurosystem but will not apply to holdings at the ECB’s deposit facility.”
3. “The volume of reserve holdings in excess of minimum reserve requirements that will be exempt from the deposit facility rate – the exempt tier – will be determined as a multiple of an institution’s minimum reserve requirements.”
4. “The multiplier that will be applicable as of that maintenance period will be set at 6.”
5. “The exempt tier of excess liquidity holdings will be remunerated at an annual rate of 0%. The non-exempt tier of excess liquidity holdings will continue to be remunerated at zero percent or the deposit facility rate, whichever is lower.”
So do the sums again:
1. As at July 30, 2019, the excess reserves stood at 1,204.3 billion euros (Source).
2. The overall required reserves were 132 billion euros.
3. So 6 times 132 = 788.4 billion euros, which comprise the ‘exempt tier’ from the deposit rate of -0.5 per cent.
4. Thus, when the deposit rate was -0.4 per cent without the tiered approach, the penalty was 4.81 billion euros. With the tier at the deposit rate of -0.5 per cent, the penalty falls to 2.078 billion euros, a ‘saving’ of 2.738 billion euros.
And who benefits from the tiering initiative the most?
You got it – the German banks.
They account for around 35 per cent of the excess reserves in the Eurosystem.
French banks account for around 22.5 per cent of the excess, Dutch banks 12 per cent, then banks in Finland, Luxembourg and Spain.
I will write about the distribution of the excess reserves – the reasons and implications – in a later blog post.
But the point is that the German banks gain the most from the introduction of the two-tier system.
(iii) Nagusitasun fiskalaren garaia etortzen ari da
The period of fiscal dominance is approaching
The most important aspect of the ECB’s latest policy machinations is that they broaden the group of commentators and observers that are realising that monetary policy is being pushed further into the non-standard realm yet the effectiveness of these shifts is increasingly questioned.
The ECB has been forced by the straitjacket that the Treaty laws have placed Member State governments in to increasingly entertain so-called ‘non-standard’ monetary interventions.
We have an array of policy interventions that the ECB has introduced over the last seven years in a desperate attempt to maintain their price stability charter (they have failed) and stimulate the stagnant European economies (mostly failed).
While previous ECB policy positions were defined in terms of end-dates, the latest statement makes it clear that interest rates will remain low:
… until we have seen the inflation outlook robustly converge to a level close to, but below, 2%.
The most significant point that emerged from the ECB’s press releases and interviews last week, was Mario Draghi’s insistence that:
First of all let me start from one thing about which there was unanimous consensus, unanimity, namely that fiscal policy should become the main instrument … it’s quite clear that in order to raise demand in an effective … you’ve seen the language of the Introductory Statement after many years I think of being more or less the same about fiscal policy that has changed and I think there was complete agreement about that …
… it’s high time I think for the fiscal policy to take charge.
The ECB is thus now joining the chorus despite renegade statements from officials from the Bundesbank, Nederlandse, and the Oesterreichische Nationalbank, and others who continue to claim that the Eurozone is operating at full employment and that interest rates should rise not fall.
Bundesbank boss Jens Weidmann said in the Bild-Zeitung interview that it was crucial, in the words of Bild, that “monetary policy does not become harnessed to fiscal policy, because that jeopardises the central bank’s ability to keep prices stable.”
In his own words, he told the newspaper that:
The decision to buy even more government bonds has exacerbated this risk, and it is becoming increasingly difficult for the ECB to exit this policy.
The problem for the likes of Weidmann is that the horse bolted long ago and the evidence base fails (dramatically) to support his inflation obsession.
Ondorioak
The most important aspect of the ECB decision was not the monetary policy changes, which will have relatively minor impacts on the real Eurozone economy.
The telling part of the whole episode was Draghi’s comments on fiscal dominance.
We are entering a new era where the neoliberal obsession with so-called monetary policy reliance is becoming increasingly discredited and exposed by the evidence base.
Fiscal dominance is approaching.
And the only body of work that has consistently argued for this approach to macroeconomic policy making has been Modern Monetary Theory (MMT) despite what the mainstream economists who are now starting to realise their reputations are in tatters might say.
Berriz, euskal ‘kazetariak’, politikariak, ekonomilariak, progreak, sasi intelektualak, eta abarrak ez dira gai Mitchell-ek aipatzen duena ulertzeko.
DTM-ren garaia hemen dago!
joseba says:
Derek Henry:
http://bilbo.economicoutlook.net/blog/?p=43183#comment-64762
I love your optimism Bill.
Before fiscal policy rises from the ashes again the banks will need to be put back in their box and be bowler hat boring again. There’s not one political party in the West willing to take them on. (…)
The SNP gave me a little hope but it was false hope built in lies and deceit, as they have chosen the Irish model and to be at the heart of EU central.
Today where is the changes going to come from ? I simply do not see any political party willing to do what is needed
joseba says:
When old central bankers know what is wrong but can’t bring themselves to saying what is right
(http://bilbo.economicoutlook.net/blog/?p=43330)
Last Friday (October 4, 2019), a group of former central bank governors and/or officials in Europe, issued a statement damming the conduct of the European Central Bank. You can read the full text at Bloomberg – Memorandum on ECB Monetary Policy by Issing, Stark, Schlesinger. The timing of the intervention is interesting given the change of boss at the ECB is imminent. As I explain in what follows, the Memorandum should be disregarded. Its central contentions are mostly correct but the alternative world it would have Europe follow would be a disaster for many of the Member States and the people that live within them. It would almost certainly result in the collapse of the monetary union – which would be a good outcome – in the face of massive income and job losses and the social and political instability that would follow – which would be a bad outcome. What it tells me is that the monetary union is a massive failure. It would be far better to dissolve it in an orderly manner to avoid those massive income and job losses and to support the restoration of full currency sovereignty and national central banks. That would be the sensible thing to do.
My analysis of the ECB’s latest monetary policy decisions were in this two-part blog post series:
1. ECB confirms monetary policy has run its course – Part 1 (September 17, 2019)
2. ECB confirms monetary policy has run its course – Part 2 (September 18, 2019)
Essentially, the ECB is pushing its available policy space into rather ridiculous terrain as it faces an economy that is moving towards recession and doesn’t anticipate any reasonable fiscal response coming from Brussels.
The crazy monetary policy parameters are demonstrating the dysfunctional architecture of the monetary union that was deliberately created as an expression of neoliberal ideology.
The design of the EMU was never going to be capable of resisting a major economic downturn and events proved that to be the case.
The only reason the common currency is still intact after the GFC is because the ECB stretched its mandate – violated its Treaty obligations – and became a de facto fiscal authority.
But it also undertook this role in a highly compromised manner because, in saving governments from insolvency, they also enforced damaging conditionality on the same governments which locked them into a vicious cycle of stagnation and fiscal trauma.
In this role, and more formally as a member of the Troika (with the European Commission and the IMF), the ECB gave up any pretense of being an ‘independent’ player in the monetary system.
(…)
As to Otmar Issing, on February 15, 2010, he wrote in a Financial Times Op Ed – Europe cannot afford to rescue Greece – that any ‘bail out’ for Greece (this was in the period leading up to the bail outs):
… would violate EU treaties and undermine the foundations of Emu. Such principles do not allow for compromise. Once Greece was helped, the dam would be broken. A bail-out for the country that broke the rules would make it impossible to deny aid to others.
His view was that the by “joining Emu, a country accepts its rules” and that the “Emu is a ‘no transfers’ community of sovereign states”.
And that “Transferring taxpayers’ money from countries that obeyed the rules to those that violated them would create hostility towards Brussels and between euro area countries”.
He also considered that Greece had “wasted potential savings in a spending frenzy” and, as such, the crisis was of their own making and that they should solve it.
He didn’t offer a solution to Greece’s plight at the time other than to lay blame at its doorstep and to offer gratuitously that:
This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances.
In other words, endure more or less permanent depression.
He did not comment in 2003, when Germany became the first of two nations to break the Stability and Growth Pact and then bullied the European Commission into having the rules relaxed. France was its partner in crime.
During the recession in 2003 it became obvious that Germany would violate the SGP rules and the Commission placed them within the ‘Excessive Deficit Mechanism’, which required Germany to “put an end to the present excessive deficit situation as rapidly as possible”.
The European Commission solution – following the Issing mindset that rules have to be obeyed – made matters worse in both Germany and France.
The question should have been about why the ‘rules’ were deemed to be appropriate benchmarks for the Member States to achieve rather than imposing them without context.
I wrote about that extensively in my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale.
You can read the trail of notes on this specific topic that I compiled as part of the writing exercise for that book starting with this blog post – Options for Europe – Part 63 (April 11, 2014).
Another contributor to the Memorandum published on Friday, Jürgen Stark, is also behaving in a consistent, if misguided fashion.
Just after the ECB introduced its Securities Markets Program (SMP) in May 2010, which effectively saved the Eurozone from breakup, there were a series of high-level resignations from the ECB Executive Board.
The fiscally-conservative boss of the Bundesbank, Axel Weber, who was being touted to replace Jean-Claude Trichet as head of the ECB, announced he was resigning, ostensibly in protest of the SMP and the bailouts offered to Greece and Portugal.
In a speech presented to the Shadow Open Market Committee (SOMC) symposium, New York City on October 12, 2010 – Monetary policy after the crisis – a European perspective – Weber demonstrated that he knew quite clearly that the ECB was:
… blurring the different responsibilities between fiscal and monetary policy. As the risks associated with the SMP outweigh its benefits, these securities purchases should now be phased out permanently as part of our non-standard policy measures.
In November 2011, ECB Executive Board member, Jürgen Stark followed suit and resigned in protest over the SMP.
Stark told the Austrian daily, ‘Die Presse’ (September 21, 2012) in an interview – Stark: “EZB bewegt sich außerhalb ihres Mandats” – that the ECB was heading in the wrong direction by pushing aside the crucial no bailout clauses that provided the bedrock of the EMU.
He said that (my translation) “within hours, an important economic foundation of the Economic and Monetary Union was simply pushed aside: the no bail-out clause … the ECB is moving away from its mandate …”
He also said that the ECB had panicked by caving in to the pressure from outside of Europe.
His concern?
… the potential for inflation has grown enormously.
Whatever spin one wants to put on the SMP, it was unambiguously a fiscal bailout package. The SMP amounted to the central bank ensuring that troubled governments could continue to function (albeit under the strain of austerity) rather than collapse into insolvency.
Whether it breached Article 123 is moot but largely irrelevant.
The SMP reality was that the ECB was bailing out governments by buying their debt and eliminating the risk of insolvency. The SMP demonstrated that the ECB was caught in a bind.
It repeatedly claimed that it was not responsible for resolving the crisis but, at the same time, it realised that as the currency-issuer, it was the only EMU institution that had the capacity to provide resolution.
The Germans were consistently opposed to the ECB acting in this way but there opposition was effectively reflecting their inflation angst – which is a paranoia that distorts reasonable judgement.
The events that have followed in Europe and Japan’s experience since the early 1990s indicate that their fears of inflation were not based on any fundamental understanding of what actually was happening.
(…)
But the point the Memo wants to make, which is a point I made above (and extensively in my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale) is that QE (massive government bond buying) is motivated by:
… an intent to protect heavily indebted governments from a rise in interest rates … From an economic point of view, the ECB has already entered the territory of monetary financing of government spending, which is strictly prohibited by the Treaty.
Exactly true.
The European Commission has been playing ‘nod, nod, wink, wink’ with the ECB since the crisis began.
When convenient, the EC invokes the Treaty to threaten Greece or Italy or whoever, but it knows as well as anyone that without the massive QE programs (in their various guises) the monetary union would not have survived the certain insolvency of several key Member States (such as Italy in June 2012).
So they all play along with the charade that the massive expansion of the ECB’s balance sheet is to facilitate liquidity arrangements in the cash markets, when they know full well, the ECB is playing a fiscal function, to make up for the deliberate neglect of such a function in the Treaty.
It is pathetic really.
But the question and focus should be to demand such a fiscal function be created at the ‘federal’ level rather than demand the ECB cease keeping Member States from insolvency.
Fourth, the Memo rails against the “very low or negative central bank interest rates”, claiming that such measures are deflationary.
MMT economists have long pointed out the same conclusion. Increasing interest rates are likely to exacerbate inflation because of the income effects.
Cutting rates to negatives, undermines income flows to the non-government sector and as the Memo notes deprives people “of the opportunity to provide for their old age through safe interest-bearing investments.”
As I noted last week, the financial market players I met with in Europe are crying out for fiscal action to provide growth and investment opportunities given that many pension funds and insurance funds are teetering on the edge of insolvency due to maturity mismatches and increasingly riskier investment positions as they chase yield in this negative interest rate environment.
The conclusion is that a reliance on monetary policy has destabilised the whole financial system and a return to fiscal dominance is essential.
Of course, the Memo only acknowledges the first part of that conclusion and would eschew the second part (although is silent on it).
(…)
The question the Memo avoids is that this compromise is a direct result of the creation and design of a monetary union that could never withstand a major negative spending shock.
By surrendering their own currencies, and, adopting a ‘foreign’ currency (the euro), the Member States became the prey of the bond markets. Only the exercise of the ECB currency issuing power which gives it the unlimited capacity to buy any debt issued in that currency (government and private) has stopped the bond markets from pricing governments out of regular funding.
The problem is not the loss of independence but the fact that there is no fiscal authority that can insulate the Member States from insolvency.
Conclusion
The Memorandum should be disregarded.
Its central contentions are mostly correct but the alternative world it would have Europe follow would be a disaster for many of the Member States and the people that live within them.
It would almost certainly result in the collapse of the monetary union – which would be a good outcome – in the face of massive income and job losses and the social and political instability that would follow – which would be a bad outcome.
What it tells me is that the monetary union is a massive failure.
It would be far better to dissolve it in an orderly manner to avoid those massive income and job losses and to support the restoration of full currency sovereignty and national central banks.
That would be the sensible thing to do.
joseba says:
Bill Mitchell-en The ECB is facing a crisis – rising inflation and risk of Member State insolvency – how to make a problem
(http://bilbo.economicoutlook.net/blog/?p=48916)
The Eurozone continues to stumble on, held together by the vast bond-buying program of the ECB, which has saved several Member States from insolvency over the last several years. While all the talk at present has been about what to do about the punitive and unworkable fiscal rules in a post-pandemic (when will that be?) period, when the emergency waivers of the Excessive Deficit Mechanism procedures are withdrawn, the reality is that under the current architecture, the only thing that keeps the currency union intact is the ECB acting outside of the legal structures set down by the treaties. Yes, I know full well that the elites have massaged the public into believing that there is no breach of the no bailout clauses, but the reality is different. The ECB is (indirectly) funding Member State fiscal deficits through its massive asset purchasing programs, the two relevant ones being the PSPP and the PEPP. And ever since they introduced the Securities Market Program (SMP) in May 2010 they have been providing funding to Member States to allow them to run fiscal deficits while maintaining low bond yields. With the Pandemic Emergency Purchase Programme (PEPP) scheduled to end in March 2022, the fears are growing that Italy will be the first Member State to succumb to the bond markets – the yields on debt will rise because the investors appreciate the credit risk and will know they cannot offload as much debt onto the ECB in the secondary markets. The fact that these fears are becoming more widespread should tell you that the role of the ECB is exactly what I say it is rather than the ‘maintaining order in investment markets’ spin that the ECB runs as the smokescreen.
The ECB is now approaching a crisis situation.
With the inflation rate (currently at 4.9 per cent per annum) well above its definition of price stability (2 per cent) it is being pressured to abandon its various bond purchasing programs.
This is based on the mainstream argument that the liquidity pumped into the reserve accounts of banks via the various bond-buying programs is inflationary – the so-called ‘printing money’ myth.
The ECB is full of economists who believe that sort of fiction.
To some extent the ECB has reduced pressure on itself to act by adopting a symmetric approach to their price stability target.
The US Federal Reserve led the way in this respect in August 2020 when it effectively abandoned the NAIRU-forward looking approach to monetary policy setting and instead said it would tolerate temporary deviations in inflation from its price stability target as long as the unemployment rate was still falling.
They had reprioritised policy to target the irreducible minimum unemployment rate instead of using unemployment to discipline price pressures that they
‘expected’ to occur, even if the pressures were not evident in the data.
That was a massive shift in thinking by the central bank and represented a rejection of the mainstream NAIRU approach that has dominated policy setting for 3 or more decades.
So the ECB can always say the current inflation is transitory (an assessment that I agree with) and that they will continue to support the real economy.
Their dilemma is, of course, that they know full well, even if a host of mainstream economists like to deny it, that their bond-purchasing programs are the only thing standing between several Member States remaining solvent and having to declare bankruptcy.
Remember the 19 Member States in the monetary union, effectively use a foreign currency having surrendered their sovereignty when they entered the eurozone at the turn of the century (for some and later for others).
That means that they have to rely on taxation revenue to spend in euros and if they want to spend more than that tax revenue, then they have to convince the bond markets to loan them euros.
The bond markets know each Member State has credit risk, which means the governments can run out of euros if they cannot get them from the markets.
And as deficits rise to deal with the pandemic, that risk rises and the bond markets demand higher yields on the loans they extend to the governments to offset the rising risk of default.
At some point the yields would get too high and the government would not be able to continue without some sort of default.
Enter the ECB.
They can ensure the bond markets keep extending loans to the Member States by making it clear they will purchase the debt once bought by the private investors.
The private investors thus know they can tender for the debt, onsell it to the ECB for a capital gain and so the fiscal deficits of the Member States continue to receive the euros they need.
So the dilemma for the ECB is that they cannot really abandon these bond-buying programs no matter how much pressure they are under.
And the programs have been massive funding most of the increase in fiscal deficits since the beginning of the pandemic.
If the ECB abandons the programs, then several Member States – such as Italy – will immediately face insolvency and/or the need to invoke harsh austerity.
It is an ugly prospect.
PSPP and PEPP update
On March 18, 2020, the ECB press release – ECB announces €750 billion Pandemic Emergency Purchase Programme (PEPP) – announced an extra public and private bond buying program.
The following graph shows the 10-year government bond spreads against the German bund (percentage points) since the beginning of 2020 up until December 22, 2021 and explains the timing of the ECB’s announcement.
A localised peak in the spreads occurred on March 18, 2020 (for Greece) and March 17, 2020 (for the other nations shown).
Just like during the GFC, the ECB responded to the rising spreads, which would have been catastrophic for the Member Nations in question had they been allowed to be driven by the private bond markets, by increasing its purchases of government bonds.
The PEPP differered from the existing Public Sector Purchasing Program (PSPP), in that, it included Greece for the first time, and so the spread on the Greek 10-year bond quickly followed the downward path of the other Member States.
It also differed because it allowed the ECB to break with the stricter rules governming the PSPP, in particular that the bonds purchased from any country had to be in proportion (with ceilings) to the so-called capital key (the Member State contributions to total ECB capital)
But I think this graph makes it clear that the ECB was able to quickly manipulate the yield spreads.
These spreads are managed by the ECB through its bond-buying programs as I have explained many times before.
How does it do that?
By purchasing large quantities of government debt in the secondary bond market (which is where open trading of these assets occurs after the primary issue has finished), the ECB boosts demand for the assets, which drives up their prices.
The yields are inverse to the price of the bonds and so the increased demand pushed down yields.
To understand this, imagine there is a 10-year bond worth $100 that was issued with a coupon (yield) of 10 per cent. That financial asset requires the government to pay $10 per year for 10 years and then redeem the bond for $100 at the end of the 10-year period.
These sorts of bonds are called fixed income assets because the $10 per year doesn’t change with the current interest rates.
But imagine that the bond price is driven up to say $110 in the secondary trading, then an annual return of $10 will imply a lower yield than before.
Why?
When the bond was worth $100, the fixed annual income of $10 was a yield of 10 per cent. Now, the $10 flow each year is yielding less in relation to the current bond price of $110.
You can also see that the ECB has also managed the spreads in according with the pre-crisis relativities, which is what Isabel Schnabel referred to as their assessment of the “different fundamentals” – largely, credit risk.
The ECB now has several asset buying programs in place.
The long-standing public sector purchase programme (PSPP) (began on March 9, 2015) buys up various government bonds in the Euro area.
The ECB say that:
Since December 2018 government bonds and recognised agencies make up around 90% of the total Eurosystem portfolio, while securities issued by international organisations and multilateral development banks account for around 10%. These proportions will continue to guide the net purchases.
As at May 22, 2020, the ECB had purchased 2,216,852 million euros worth of bonds under the PSPP. The can loan some of these assets back to the markets “to support liquidty and collateral availability”, which is the way they get around the Treaty no bail-out clauses.
The reality is that the ECB is funding significant proportions of Euro Member State fiscal deficits and without these programs, several countries would have already gone broke.
In their – Public sector purchase programme (PSPP) – Questions & Answers (updated April 2, 2020) – we learn that from November 1, 2019, the ECB committed to monthly bond purchases under its Asset Purchase Program (APP), which includes the PSPP, to the value of “€20 billion.”
The ECB provides a time series of the – Cumulative purchase breakdowns under the PSP.
The following graph shows the entire history of the program since March 2015 up until November 2021.
You can see they had to go hard in March 2020 as the bond markets started to demand higher yields. Once the ECB had controlled the spreads, they were able to maintain a lower level of purchases under this program.
They introduced the PEPP on top of the existing PSPP in March 2020.
The problem with the PSPP was that the ECB could not hold more than a certain proportion of each Member States debt and that those limits would have been exceeded in this crisis given its scale.
They could have just abandoned those voluntary limits but that would have forced them to make admissions about what they were actually doing, even though it was clear for all to see.
So, instead, they they chose to create a new, more flexible program called the – Pandemic emergency purchase programme (PEPP).
The ECB explained the difference between the PSPP and the PEPP programs in this document (April 2, 2020) – Pandemic emergency purchase programme (PEPP) Questions & Answers.
Purchases began on March 26, 2020.
To the end of November 2021, the ECB has purchased a cumulative total of 1,548,231 million euros worth of government bonds.
Italy facing renewed crisis
The pandemic has not been kind to Italy.
To support households and firms, the Italian deficits have risen as has its public debt to GDP ratio (from 134.8 per cent in 2019 to around 155 per cent in 2021).
Last year, the deficit was 9.5 per cent of GDP, which is the highest level since the early 1990s, when the recession had a massive negative impact on the Italian economy.
We expect, based on Italian government estimates that the deficit in 2021 will rise to 11.8 per cent of GDP.
Earlier in 2021, it has estimated the deficit would be just 8.8 per cent, but, such has been the deterioration in the situation, that the fiscal support had to be increased.
The Italian government has been able to fund those deficits largely because of the PSPP and PEPP conducted by the ECB.
If the ECB was to taper and subsequently abandon the PEPP in March 2022, as it has suggested then Italy would face rising yields and eventually not be able to fund its deficits.
That prospect would intersect with an economy that was struggling to recover from the pandemic, and, was already stagnating.
Italy is not Greece.
The European Commission could eviscerate Greece because it is small relative to the overall EU economy.
Not so Italy.
If austerity was imposed on Italy to reduce the deficit (as bond yields rose) and/or Italy considered defaulting on its debt then the whole monetary union would be threatened.
The EU cannot afford to let Italy stumble.
The ECB knows this and so any talk of the PEPP being abandoned is dangerous because of the functional role it plays in maintaining Member State solvency.
Some people are calling this a ‘doom loop’.
I have consistently made this point.
The inherent architecture of the money union predicates it to crisis.
The ECB has to ‘break the law’ for the union to survive.
Fiddling around the edges of the fiscal rules will not cut it.
The problem is the euro!
Conclusion
The dysfunctional architecture of the Eurozone continues to amaze.
It also puts the ECB in a bind.
I don’t expect it will withdraw its bond-buying programs any time soon irrespective of the course of inflation.
It simply cannot unless it wants to send a few Member States broke and take the political consequences.
What a crazy system!