Has the ECB provided the missing piece to resolve the EU debt crisis?

On September 6, Mario Draghi, president of the European Central Bank (ECB), announced that the ECB would engage in unlimited secondary market purchases of government bonds of member countries adhering to the policy conditions agreed to with the IMF and EU (and thus qualified to borrow from the European Financial Stabilization Fund – EFSF – or the European Stabilization Mechanism – ESM) to the extent needed to promote the efficient transmission of monetary policy throughout the Euro area. The over all liquidity impact of such purchases will be sterilized (offset by the sale of some other ECB assets), as needed, in order to preserve the ECB’s inflation objective of an inflation rate below but near 2% over the next two years. What does this add to the existing European tool kit and is it enough to resolve the EU debt crisis?

All responsible government officials recognize and accept that in the long run nations, like individuals, must live within their means (pay fully for what they consume). Their standard of living will depend on what they are able to produce (productivity).  Eliminating government deficits requires reducing government spending and/or increasing its tax revenue. Increasing the sustainable standard of living of its people (the level of consumption they can fully pay for with what they produce) requires liberalizing restrictions on labor and product markets and investment that will increase the productivity and thus output of workers and businesses. The debate is primarily over the optimal pace of introducing the measures needed to balance budgets and increase productivity and competitiveness.  This matters in that it takes time for the economy to adjust to reforms before it enjoys the benefits of more rapid growth. In the interim continuing but declining deficits must be financed either in the market (if market lenders have confidence in the effectiveness of the measures being taken), or by the IMF/EU/ECB until market confidence can be established.

I have elaborated these points in earlier blogs: “European debt crisis: causes and cures”; “Saving Italy and the euro”;   “Buying time for Italy”; and “Saving Greece-Austerity and/or Growth”.

Throughout the crisis Germany has demanded that Greece and other over indebted and uncompetitive countries undertake the needed corrective measures before being granted the financing needed for the transition back to normal market borrowing.  Events have proven Germany to be right as earlier “bailout” commitments have led to a suspension or slow down in policy reforms thus prolonging recovery.  For the same reason Germany has vigorously opposed (correctly in my view) the adoption of Eurobonds, which would allow Greece and others to borrow at the same interest rate as Germany and all other EU members. The moral hazard of bad fiscal behavior when market discipline of over borrowing is removed is a real and serious issue.

On the other hand, Germany is also pushing for Fiscal Union in order to gain better EU wide control over excessive national deficits. This may or may not be a good idea for Europe (I have my doubts) but it is certainly not, contrary to much opinion, essential for the viability of the Euro. The idea behind the German push for Fiscal Union stems from the markets’ failure to properly price the risk of lending to Greece, Portugal and some other overly indebted countries and Germany’s belief that the only way it can protect its tax payers from supporting inflated living standards to the South is by gaining control over their governments’ expenditures. Until the last few years, the governments of Greece and Portugal could borrow in the market at interest rates very close to the rates paid by the German government, which by the way has borrowed quite a lot itself (the ratio of German government debt to its GDP is currently above 81%). These governments spent and over promised future benefits recklessly on the (temporary) basis of relatively cheap debt financing in the market.

It is certainly a fair question to ask why the market failed in this regard and over lent to a number of governments that now have difficulty repaying. The expectation that Germany and other Northern EU countries would not allow the profligate southern ones to default made such lending seem risk free and the market priced it accordingly.  Fiscal Union and/or EU-wide fiscal rules are one way to limit such excessive borrowing and unfunded future promises. Improved market discipline of borrowing via more accurate risk premiums on market lending is another, and in my opinion, superior approach. Greece’s orderly default (75% haircut) on its publicly held debt and the current crisis have restored a large measure of market discipline to sovereign borrowing. Greece and Portugal do not need to borrow from the market for several more years as long as they implement and adhere to the reforms demanded by the IMF/EU/ECB. However, Spain and Italy closely watch the now far more sensitive interest rates demanded by the market when lending to them. Given the substantial outstanding debt of these countries, those interest rates can make the difference between the success or failure of reform efforts. Ireland, which has successfully, though painfully, implemented all of the conditions of the IMF et al “bailout,” is well on the way to full recovery and is now able to borrow again in the market at reasonable interest rates.

The missing piece in the EU/ECB tool kit to manage the ongoing debt crisis is the availability of sufficient temporary adjustment financing for larger countries such as Spain and Italy should markets loss confidence in one or both of them before their reforms have had time to bear fruit. The resources of the EFSF/ESM, still waiting for the German constitutional court’s approval, are not sufficient to finance stabilization programs with both countries. This leaves markets uneasy and volatile.  Market interest rates on ten-year Spanish government bonds have varied this year between under 5% to 7.6%. German government bond rates have varied between 1.24% and 1.85%.  Mario Draghi’s commitment of ECB funds to buy short-term sovereign debt (with maturities of up to three years) in secondary markets does not augment the resources available to the EFSF/ESM to finance adjustment programs with the IMF, but by buying such bonds in the secondary market should liquidity in a program country dry up, the ECB should be able to significantly reduce the prospects of what it considers unrealistically high risk premiums for such bonds. The ECB would only buy bonds of countries meeting the conditionality of an IMF supported adjustment program. Outright secondary market purchases are a standard and traditional liquidity management tool for central banks. What is unique in the European context is that open market purchases must be for the bonds of individual countries and the choice of countries matters. It is for others to determine whether, as Mr. Draghi claims, the new initiative is consistent with the ECB’s mandate.

This past week I attended a meeting of the Mont Pelerin Society in Prague. Friedrich Hayek, Milton Friedman and a few other free market champions founded the MPS in 1946. Czech President Vaclav Klaus, also an MSP member, hosted this year’s meeting. President Klaus has opposed the Czech Republic’s adoption of the Euro. It has kept its own currency, which the Czech National Bank has managed very well under an “inflation targeting” policy regime. However, Spanish economist Jesus Huerta de Soto spoke at the meeting in defense of the single currency. He favors a return to the gold standard but convincingly argued that the monetary discipline on Spain provided by giving up its own currency to the Euro was a good second best.  The key to success or failure of the Euro for the overly indebted countries that use it is whether they reform deeply enough to live within their own means within a few years and to sufficiently improve their competitiveness with the rest of Europe and the rest of the world. Failure to do so will harm the defaulting country far more than it will harm the Euro.  I wish them well.

Spain’s Financial Crisis: First Principles

Europe’s debt crisis has many contributing elements: bloated government bureaucracies, unaffordable social welfare programs, and productivity stifling labor and commercial laws.  However, none is as central as the condition and behavior of those European banks that overlent to and undercharged many European governments, and whose potential insolvency should one or more European governments default (as Greece has already to some extent) has dominated the EU’s slow, halting approach to dealing with it. Focusing on the case of Spain, the following note illustrates the importance for the future of Europe’s financial markets of resolving the banking sector’s problems properly.

Overview

In some respects the financial and debt situation of Spain is similar to that of the U.S.[1] Its central government debt is less than the U.S.’ and Germany’s (68%, 103%, and 83% respectively). This year its public sector deficit is expected to be 5.9% (8.5% last year), less than the U.S. at 7.6%, but more than Germany’s at 1.3%. Its total debt (public and private) to foreigners (external debt) is less as well (84%, 103%, and 142% respectively). Spain’s housing bubble and subsequent collapse were average. The decline in Spain’s real housing prices from their peak in 2007 of about 20% was about the same as the UK’s and the Euro zone’s and less than in Ireland and the U.S.

To over simplify, what sets Spain apart is a) its lack of competitiveness (its current account deficit with the rest of the world relative to GDP was 9.6% in 2008 and is currently almost 3% while the Euro area as a whole is balanced – i.e., 0); b) the heavy reliance of its banks on borrowed funds (its loan to deposit ratio is about 150% compared with 80% for U.S. banks; and c) its banks’ large exposure to the real estate and construction sectors (56.5% compared to 30% for U.S. banks). In addition, Spanish and European banks in general operate on much less capital than do American banks. Going into the recent financial crisis—2007—the ratio of total European bank assets to capital—i.e., the leverage ratio—averaged around 30, while for American banks it averaged around 13 (i.e. capital gearing ratios of 3.3% and 7.7% respectively).

Spain was confident that it could make sufficient budgetary and policy adjustments to convince markets that it was still safe to lend to while gradually winding down excess spending and liberalizing rigid labor and product markets (its no bailout strategy). But after four years of inadequate measures Spanish voters ousted the Socialist Party and gave the center right party of Mariano Rajoy a solid majority in Parliament with a mandate to move more aggressively. Prime Minister Rajoy’s reform program has been a mixed bag (see “Spain’s Economic Reforms: A Mixed Bag”). The central government’s spending and deficit are falling rapidly, though excessive regional government spending remains a problem. Labor market reform has been quite quick and strong and is already producing improvements in competitiveness. However, Spain has fallen back into recession and unemployment is the highest in Europe at over 24%.  (see Rajoy government reform program)

Spain’s Banks

Spain’s primary vulnerability comes from its banks. In fact, a central feature of the European debt crisis is the relatively large exposure of European banks, including German banks, to the sovereign debts of Greece, Portugal, Ireland, Italy, Spain, etc. If depositors think that their deposits are at risk, they will move them. If they think all banks in Spain suffer this risk, they will move them out of Spain to other banks that accept Euros. If depositors withdraw their deposits too rapidly (i.e., bank runs) then even solvent, well capitalized banks can have trouble liquidating assets fast enough to fund the withdrawals. The total deposits of Greek banks have fallen from 245 billion at the end of 2009 to 175 billion at the end of April 2012. However, Spanish banks’ deposits have not begun to decline until very recently.

Countries limit the risk of deposit runs by explicitly insuring bank deposits up to a limit and/or by standing ready to intervene (bailout) failing banks. In Spain, all deposits are insured up to 100,000 per depositor. If governments guarantee all deposits as a result of a comment to bail out insolvent banks, deposit insurance is redundant and not needed. Even a full deposit guarantee provides some market discipline of bank behavior if the regulator intervenes promptly when a bank becomes insolvent, because shareholders lose all of their investment in the bank. Market discipline is strengthened further if bank bondholders also incur losses when the assets of an intervened bank are not sufficient to cover their repayment.

The Importance of Bank Capital

Without deposit insurance or government deposit guarantees, their bank’s capital is the primary protection for depositors against the risk of loss.  If depositors think that their bank’s capital is too low to cover potential losses, they will move their deposits to safer banks. Unfortunately, the value of a bank’s capital cannot be known with certainty. Economic capital (net worth) is the difference between the value of assets and the value of liabilities. A large share of banks’ assets is loans. The value of a loan is less than its face (book) value if it is not repaid fully or on time. It is impossible to know for sure which loans are “good” and which are doubtful and how doubtful they might be in the future.

Minimizing the risk of deposit runs via capital adequacy consists of three elements:

  1. The level of capital banks are required to hold in normal times (dynamic or cyclically adjusted capital requirements deserve more serious attention) must be sufficient to absorb possible losses. Higher capital requirements provide more deposit protection.
  2. The rules for valuing assets and thus capital must reflect their real value as best as possible. Most bank loans have no secondary market from which to measure their value. Thus bank regulators have established rules of thumb for estimating the probable loss in value for loans that are not performing or are at risk of falling into arrears and potentially defaulting. Banks are required to provision (write down capital) to cover such probable losses. This is the equivalent of “marking to market” the probable value of loans that have no market. Loan valuation and loan loss provisions need to realistically reflect and cover the most likely repayment outcomes.
  3. Depositors must have confidence in the adequacy of the first two measures and the faithfulness with which banks apply them. This is the issue of transparency. The recent deployment of stress tests, when properly explained (especially when undertaken by third parties, such as the IMF), is meant to reduce the uncertainty surrounding the adequacy of measured capital.

The risks to Spanish bank depositors come primarily from three sources:

  1. The potential losses from loans to Spain’s now busted housing and construction markets and from holdings of sovereign debt of Greece are uncertain and have almost certainly been underestimated and under provisioned in the past. Significant exposure to Spanish sovereign debt is now becoming an issue as well. Capital injections are needed just to keep actual capital at currently reported levels. Higher levels of capital are needed to compensate depositors for the uncertainty of the actual level of capital.
  2. The ability of Spain to honor its deposit insurance commitments or its implicit commitments to cover deposits in the event of an intervention are increasingly in doubt because the ability of the Spanish government to borrow additional amounts to cover such commitments is in doubt.
  3. The ability of banks to fund their loans from non-deposit sources or to fund deposit withdrawals even if they are well capitalized are in doubt in current market conditions. This is a liquidity problem, not a solvency problem, and should be handled by the provision of central bank liquidity.

Spanish banks fund a large part of their loans with relatively short-term borrowed money rather than deposits. Access to such funds has become difficult and expensive. From the beginning of central banking, a core function of central banks has been to provide banks with the liquidity they need in such circumstances. The long-established principle is that the central bank should provide illiquid but solvent banks with all the liquidity they need (generally by lending to them against good collateral), but should not lend to insolvent banks (banks lacking sufficient good assets to cover their deposit and other liabilities). The ECB’s three-year Long Term Refinancing Operation is addressing banks’ liquidity problem (#3).

But even without deposit runs (or walks), Spanish and other European banks (especially) need to reduce the extent to which they lend long-term on the basis of short-term borrowed funds. They can only do so by reducing lending until their deposits finance a larger share of it and/or by increasing capital. The bank deleveraging now underway around the world is an important source of reduced bank lending and the slow pace of recovery (see Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different: Eight Centuries of Financial Folly”).

Spanish banks were better capitalized than most at the onset of the international financial crisis but more recently have been overwhelmed by the magnitude of the collapse of Spain’s housing and construction markets. The government (previous and current) has taken measures to address banking sector weaknesses but always a bit behind the curve.  Seven failing cajas (regional savings banks heavily exposed to real estate) were merged in 2010 to form Bankia making it Spain’s fourth largest bank. In May the bank was largely nationalized (costing the Spanish government around 20 billion Euros to date) and trading of its shares was suspended on May 25, 2012. Deposit insurance was established then raised. Government guarantees of senior bank bond holdings were introduced (October 2008).

As time passed, depositors have only become more concerned about the safety of their deposits. In an effort to finally get ahead of the curve, the authorities have increased the provisions required against weak and doubtful loans and other assets, and initiated third-party stress tests of its banks. The IMF’s recent Financial Sector Stability Assessment found Spain’s large internationally active banks to be well capitalized and able to absorb the new capital strengthening requirements. However, its former savings banks and some of its medium and small private sector banks are more vulnerable and will need capital injections from the government to cover insured or guaranteed deposits. Because of its own financing difficulties, the government of Spain has turned to the EU to backstop its ability to recapitalize (replace capital lost by or potentially lost by defaulting loans) those of its banks with inadequate capital. For this purpose the EU has committed 100 billion.

The Way Forward

Deposit runs on Spanish banks (including the drying up of wholesale funding) can be prevented only by convincing depositors that their money is safe, i.e. that their banks have sufficient capital to cover any losses. This requires honest accounting and full implementation of the indicated provisioning, and adequate capital; or creditable government guarantees.

For the future health of Spanish banks, it is important that Spain’s banking interventions preserve the intended discipline of excessive risk taking that results from imposing losses on shareholders and senior bond holders while honoring its commitments to protect depositors. Thus liquidity support should only be given to solvent banks. Nonperforming loans should be properly provisioned. Banks that are critically undercapitalized and are unable to raise their own capital to required levels within a reasonable period should be intervened. Intervened banks should be resolved according to the least cost principle (least cost to the tax payer). Shareholders and senior bondholders should be wiped out before government money is injected to cover other liabilities. Viable banks should be continued and sold to new owners within a reasonable period of time. Non-viable banks should be wound down (liquidated) paying off all insured or guaranteed depositors with the help of public funds as needed.

In requesting EU financial assistance, Spain is committed to abiding by EU rules on state aid to banks. However, emergency responses to a financial crisis much too often produce the foundation of moral hazard and excessive risk taking that creates the next crises delaying true and long-lasting resolution. More market discipline of risk taking needs to be reintroduced via a sound bank resolution policy. Spain will contribute to the future soundness and vitality of its banking sector and that of all of Europe if it adheres to the above principles as it “cleans up” its financial sector.


[1] The International Monetary Fund’s “Financial Sector Stability Assessment”  provides an excellent summary as of May 2012.

Buying time for Italy

Buying time can be useful if you get something useful with it, otherwise it is a waste of time and money. Italy needs to borrow less domestically to finance its government’s expenditures (reduce its fiscal deficit) and to borrow less abroad to finance its imports in excess of its exports (reduce its trade deficit). The lower interest cost of the IMF and/or EU lending money to the governments of Italy and Spain at German sovereign debt interest rates can buy them time to enact and implement government spending cuts, tax increases, and market reforms that improve productivity and reduce labor costs before they need to borrow in the market at potentially much higher interest rates. Why might the IMF and the EU’s European Financial Stability Facility (EFSF) be willing to lend money at German rates when market investors aren’t? That is a good question without a clear answer, though most commentators seem to assume it without much question.

The pay off from the measures Italy needs to implement will take time to materialize. Liberalizing markets takes years to actually improve productivity and exports. Some domestic wage and price deflation will probably be needed as well. Reforms to the tax system take time to produce revenue. Above all it will be difficult for the Italian economy to grow (the essential ingredient of financial sustainability) while the rest of Europe, if not the world, is stagnating. In the interim, Italy’s deficits will remain above the levels expected to result from current reforms in the future (say two to four years down the line). If they cannot be financed at “reasonable” interest rates, Italy will be forced to default on its fiscal debt of about 2 trillion U.S. dollars (of which about $500 billion falls due and needs to be refinanced in 2012). The impact on the banks, pension funds, and others that hold this debt would be devastating beyond our experience.

Thus IMF et al financing can be useful if a) Italy actually enacts and implements now the reforms needed to become viable in the future, and b) if the IMF is more confident that Italy will achieve the desired outcome than are market lenders. Without condition “a”, buying time is a waste of time because Italy would default anyway only somewhat later after running up even more debt. With regard to “b”, it may be that the IMF is better able to assess and enforce Italy’s reforms than the market (the IMF reviews progress every quarter against agreed performance criteria before authorizing the next quarterly tranche of its loan), but it is not obvious that this is so. Market lenders can see any reforms actually undertaken and the result almost as easily as the IMF can. If these measures are credible and convincing, market lenders will reduce their risk premiums for lending to Italy. If so, no funds from the IMF would be needed.

On the other hand, lenders may have become risk averse in the conditions now existing in Europe and the U.S. and world economy. If so, they will demand an interest rate to lend to Italy that is more than the premium needed to cover the expected loss from default. In these conditions IMF/EU financing could make the difference between success or failure. Undermining confidence in the ECB and the purchasing power of the Euro would be bad under all scenarios. While more rapid growth in the supply of Euros as the result of ECB purchases of Italian and Spanish debt might not be expected to be inflationary in today’s depressed economies, the effect on Euro interest rates will depend heavily on public confidence in the ECB’s anti-inflation commitment (i.e. inflationary expectation. See my earlier note on the role of the ECB: https://wcoats.wordpress.com/2011/11/17/saving-italy-and-the-euro/).

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Comments:

Here are some interesting comments from friends on my earlier note on the use of the ECB to buy Italian debt.

Thanks Warren, it is hard to be optimistic that the politicians and technocrats of Europe will stumble on the only thing that will work.

Thought experiments: why do we never see calls for “break up of the $ zone” such as when Puerto Rico got into fiscal troubles (see Stossel and Cal Thomas or recent reforms)?  Why don’t El Salvador, Ecuador and Caribbean Islands “leave the $ zone” so they can devalue to prosperity?  So far, we have a credible “no bailout policy” so even Harrisburg must go into bankruptcy.  In the US $ zone, counter-party risk is still important.

What if: instead of a “euro zone” we had seen 16 countries in the EU unilaterally adopt the DM?  The Frankfurt-managed currency would have appreciated sharply in recent years compared to the US $, much like the C$, Aus$, et. al.  The adopting countries would then have been in the position of Chile 1981.  When pegged to a weak US $ during the Carter years, Chile thought pegging was great.  Then, on the first Tuesday of November 1980 the US $ started to appreciate, and Chile found themselves holding the tail of a tiger until they rediscovered the virtues of floating.

If Italy and others are to stay on the “paper-gold standard” of Frankfurt, they will have to reduce real wages (& pensions etc.) the old fashioned way.  If that is too painful politically, and if Frankfurt refuses to abandon administration of “paper gold”, then Italy, et. al. must remain the Appalachia of the euro zone.

Why would Cameron want the ECB to monetize euro-zone debts?  Is it because more inflation in the euro zone as well as the US will take the pressure off the UK pound?

Jerry [Jordan, former President of the Federal Reserve Bank of Cleveland]

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Warren,

You make a very elegant and compelling case. But I’m not convinced that it will work. The likelihood of the ECB remaining politically independent is slight. And the only way Germany will be able to enforce the kind of austerity it’s promoting will be to invade and occupy these countries’ finance ministries (which has already begun, but without decisive popular support). Just as in the US, the people who need to bear the brunt of a recovery–the largest banks (in this case, the French banks which are the most exposed) and the bond markets–are the least likely to do it, and so hold a near monopoly on the recovery. At some point the people really bearing the brunt—the people least able to do it–may just give up: on the ECB, on the Euro, on the EU. Russia in the 1990s is a case in point. How many European Putins are there waiting in the wings? So long as the US and China and nearly every other power is dealing with this crisis publicly at the other end of a ten foot pole, I find your, and any other positive, outcome, very unlikely at the present moment. Sacred tenets of central banking aside, from where I sit this looks like little else besides beggar thy neighbor. On every level.

Ken [Weisbrode, in Boston]

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Hi Warren,

I don’t have the time these days to read your lengthy blog essays, alas, but I did want to make an admittedly superficial comment or two.  I really wish somebody would actually treat a sovereign borrower like an ordinary client some time.  These Greek demonstrations are disgusting. Your country doesn’t have money, and you’re insisting that it keep the generous welfare taps wide open.  Just where is the budget supposed to get the money to pay you to shut you up?  It would be wonderful if the Greek demonstrators were given what they want, the country would default in a few days, and then the banks would take over the bankrupt estate and liquidate it.  Not that banks are such wise and nice entities, but I just feel the Greek demonstrators deserve exactly this.  It’s the logical consequence of their irrational demands.

Next topic:  I’ve never understood the phrase (one that I have translated you saying many a time, I might add) that “of course, interest rates can’t go negative, so central banks are seriously constrained in their ability to loosen the money supply once the rates are down near zero already”.  Why can’t they go negative?  If the economy is so moribund that banks aren’t lending any more, only fuelling the moribundity further (not that you can fuel moribundity…), why can’t/shouldn’t the central bank loan money to the banks at negative interest in order to kick start lending and economic activity in general?  It’s Keynesian deficit spending by other means – monetary instead of fiscal.

Just having a rare moment of economic musing, sorry to bother you with my infantile thoughts.  Hope all is well with you, and that you have a good Thanksgiving.  Nailya and I will be passing through DC in the next month or so, but literally passing.  If plans change and we end up staying a little while, I’ll let you know and perhaps we can get together for a bit of socializing.  Nailya’s gotten quite interested in economic and political affairs (she never had been in Russia, because there’s no point in getting excited about something that gets arbitrarily decided by the corrupt suits in the Kremlin without regard for anybody else), so I know she’d make a lively conversationalist.

Steve [Lang, former personal Russian/English translator for Mikhail Khodorkovsky after being the same for me and the IMF]