ECB Only Possible Fallback For Eurozone Economic Woes

Includes: BEP, ERO, TLT
by: Erwan Mahe

When I say, multiple disequilibria, I am not speaking in political terms (although…), but instead referring to "bad multiple equilibria." This may, at first, appear a bit exotic, but it relates to macroeconomic fundamentals. This definition of a state in which different variables can, in the wake of a shock, return to relative equilibrium, albeit different from the preceding one, is, everything else being equal, largely used in the appraisal of negative feedback loops, as we can see in the case of the eurozone peripheral nation debt crisis .

DGSE models (Dynamic Stochastic General Equilibrium) were originally created in an attempt to synthesise Keynesian and monetarist economic schools via the application of micro models to the major economic aggregates. This approach was based on the postulate that prices will always naturally find their equilibrium in the course of price ebbs and flows. Put more simply, these DGSE models are a natural extension of the Real Business Cycle and New Keynesianism schools of economic thought.
These DGSE models, in fact, are the equivalent of tanker autopilots, which are suitable for calm seas but perfectly inadequate during storms, especially, when the tanker's staff has grown rusty at the helm after relying on these mechanisms for too long. These models totally occult what is referred to as Animal Spirits, the weight of expectations, be they warranted or not, in the setting of prices, and do not account for Negative Feedback Loops, not to mention "bubbles," because they consider that market forces are still capable of efficiently pricing goods and services.
Needless to say, we have been confronted by more market bubbles and cracks than ever in the past 15 years, which leaves a big fat, ugly stain on the reputation of the DGSE models.
The best illustration of their failure and of the possibility of multiple disequilibria can be seen in the sovereign debt crisis.
Sovereign or not…
To understand this point, all we need do is compare two examples of government debt; that of Sov countries, whose debt is denominated in their own currency and that boast their own independent central bank capable of serving as lender of last resort; and that of a Peg country whose debt is denominated in a currency the issuance of which it has no control.
  • Among the Sov countries, we include the United States, Japan, the United Kingdom and Switzerland.
  • In the Peg countries, we have the eurozone as well as emerging countries whose debt is denominated in US dollars.
When an exogenous shock destabilises a country's economic outlook and international investors begin to doubt its ability to repay its debt, they sell off the debt instruments they hold on the country, even when real interest rates are still attractive (low inflation and rock bottom interest rates). Their selling pushes up the interest rates on the country's debt, which then worsens its debt outlook, further adding to the cost of debt and sealing the vicious budget cycle, as discussed many times in the past.
In the case of a Sov country, the adjustment is made via the currency exchange rate, since investors will move toward other currencies, if they fear an country is set on a money policy course that they deem too easy. As such, the depreciation of a currency serves as an economic stabiliser, as the improvement in trading terms and in the current accounts balance relaunch the economy. In the case of the United States, all dollars sold end up in the American financial system anyway, because those who buy dollars from sellers of US debt have no other choice but to deposit them with US commercial banks or, in the case of central banks, with the Fed. As such, the Fed need only control the American interest-rate curve by using liquidities compensated at 0.25% on its deposit facility to buy government debt investors no longer want while raking in the carry trade generated by the interest-rate curve.
In the case of a Peg country, like Argentina before its default, dollars racked up by sellers of Argentine debt did not return to that country, but went to the United States. The central bank thus did not have the means to substitute itself for investors. In such a situation, we find ourselves back in the Negative Feedback Loop in which rising interest rates increase the chances of country default. This justifies the action of the first sellers while encouraging those still exposed to said country's risk to unload their remaining debt, thus leading to further hikes in interest rates paid by the country, which enhances even more the chances of default, and on and on.
The worst of it is that this situation is further worsened on the eurozone, because when bondholders start to become fearful about a country, like in the case of Greece, the euros they obtain by selling the country's bonds leave the country. After all, they have no interest in putting the money back into the country's central bank, which would logically go belly up if the government itself were to default. This phenomenon accelerates the flight of a country's bank deposits abroad, which further weakens these banks that are already suffering from the decline in their sovereign bond holdings to which they are structurally exposed.
This fragility of the banking system also reduces confidence in the government in question, since it is the vehicle that is supposed to come to the rescue (Ireland!) of the economy and prevent its total collapse. This new deterioration of the country's solvency outlook, in the eyes of investors, spurs new bond selling, which further weakens its banks, and so on and so on.
Moreover, if we add at some point in time a depeg risk, which could lead to the country floating its own currency (Argentina) or pulling out of the eurozone (Greece), savers are spurred to sell just that much faster their deposits from the country's banks and hurry them out of the country to safeguard against an inevitable currency devaluation. There is no need to draw a picture of what such a movement would do to the financial soundness of banks and governments, as the vicious circle hits banks, then the government and then banks again (since the government is viewed as unable to help them) and the government again.
PIGS nations in multiple disequilibria
Peripheral eurozone nations now find themselves in this situation of multiple disequilibria, a situation which only the ECB is capable of confronting.
The ECB is already helping to bring liquidity to struggling countries by providing unlimited financing to commercial banks for tender calls and via the easing of collateral conditions.
By intervening on the debt markets of countries not dependent on the aid programme (Italy and Spain), it put a stop to the infernal spiral affecting those those countries and which could have precipitated them into the same situation as Greece, Ireland and Portugal. I say only the ECB can fulfill this role because it had to make the first step due to the ridiculous Franco-German compromise of July 24. Having earlier required banks to participate in the second round of the Greek bailout, which left them with several billion euros in losses on their Greek bond holdings (the PSI), the central bank sucked all the other peripheral nations into the turmoil. After the ECB relentlessly promised investors for months on end that no eurozone country would be allowed to default, only to stick them with a "voluntary" loss of 21%, how could investors accord the slightest credence to ECB promises that these measures would be limited to Greece and involve no other eurozone country? Based on a supposed morality, that makes absolutely no sense, whereby investors are forced to pay billions of euros, when the money could have just as easily been lent to the country, there were hundreds of billions lost on all other assets, both in peripheral and non-peripheral nations, not to mention the share prices of companies listed on stock exchanges, among others!
The ECB must therefore do more, since current rates on Italian debt, for example, 5.55% on the 10-year segment (graph below) or 4.15% on 2-year debt (vs 0.50% in Germany), is still way too high in the current economic context, which imperils the solvency of the Italian state.
The ECB must therefore fulfill its role as lender of last resort on the eurozone, as do its peers in the United States, Japan, the UK and Switzerland. Moreover, its "orthodox" justification of "restoring the channels of monetary policy" is totally valid.
Consequently, the time is long past time for monetary authorities to wait until the EFSF, or some other intergovernmental facility, picks up the slack, or simply content themselves with assertions that the measures are only "temporary"; The ECB must clearly announce, like the Swiss have done, that long-term interest rates of eurozone nations can be no higher than 3 percentage points above its key interest rates. The rate on 10-year German bonds has never been 2.72% higher than that of the ECB's key rate, even when it was not seen as a safe refuel, and that did not, in any way, trigger an inflationary spiral in Germany!
For those worried about the impact of the ECB's adoption of such an interventionist approach on its balance sheet, should a eurozone country eventually declare default, there is no reason to be concerned. Like in the case of the Swiss National Bank with no ceiling on the CHF at €1.20, the ECB is not restricted by size in its interventions or in its balance sheet.
If its recognised capital were to someday become negative, due to such a default, it would be of no importance. Whether it decides to call on European governments to recapitalize it, credits itself with the needed capital or books it as a loss brought forward (retained earnings/losses) until offset by Seignorage income, the decision will be made on the basis of the existing macroeconomic criteria, mainly inflation.
Money is a public good, and the ECB is its depository; it is about time it makes use of that power. Its slowness in acting, seen again and again since 2008, stems from frankly archaic monetarist principles, the best illustration of which is that it created its very own DGSE model (Smets-Wouters (2003) Model) to direct its monetary policy. This model makes no references to credit or changes in debt stocks, which I guess is normal for people who have no grounding in the micro economy or who have never read Hyman Minsky.
10-year German, Italian and Spanish bonds - (click chart to expand)
Not out of the woods yet; far from it.

Disclosure: Long 18 years OAT and 28 years BTP Zero Coupons, EDF Corp 3 Years 4.5%, Greece 1 Y and 8 Y bonds,