The Question of Debt Sterilization is not for Today. But it Needs to be Discussed

Yesterday I read an interesting FT piece (signed by the editorial board) arguing against debt cancellation. The piece is interesting and in my opinion its title (The case against cancelling debt at the ECB) is misleading. Summarizing, the piece argues that today countries like Italy have no market access problem, that spreads and interest rates are at an all time low, that debt cancellation would not free cash for Italian immediate needs. This are all reasonable arguments, but they would be relevant in assessing benefits of debt cancellation for a country facing a sovereign debt crisis. The current discussion on debt cancellation is nothing of that sort. It is more similar to debates that in the past were common after extraordinary shocks such as wars or… pandemics.

So, what is wrong with the FT way to approach the issue of debt cancellation (or sterilization, as I would prefer to call it for reasons to be clear below)? First, the excessive focus on Italy is off the mark. Any serious discussion on sterilizing the exceptional debt that was generated by the contrast to the pandemics should concern all EMU countries. All of them have had a spike in deficit and debt. Second, as I said, the piece focuses on the short run arguing that debt sterilization would not bring fresh cash. Of course it would not, and of course it would not be needed. EMU public debt is today (and for a long period to come) in excess demand. On top of that, we learned yesterday to no surprise that the ECB will keep the PEPP umbrella open for a while: March 2022 at the earliest, with no tapering to begin before 2023.

Thus, the discussion should not be on short term market access or liquidity needs (nor on the macroeconomic impact of debt sterilization in the current situation). Sterilizing the EMU pandemics-related public debt is a medium term issue, related to future fiscal space. The question to ask is whether the exceptional stock of debt that built in the past few months will constrain EMU countries in their ordinary fiscal policies in the future. If the answer is yes (I believe it is), then sterilizing that debt is eventually going to be an issue to be dealt with. And in that case it is hard to imagine that the ECB will not be part of the solution. In the end, this is what the FT editorial board seems to suggest too (this is why the piece is more nuanced than the title would make it believe), when they argue that

Italy could act by itself to make its debt easier to deal with over the long run, in case the ECB ever decides to sell its holdings back to the private sector and rates go up. In particular it could issue much longer dated debt to lock in the current low rate of funding, and gain more time to fix the country’s sluggish growth rate. Italy could even try to sell perpetual debt.

In short, the piece suggests that extending the maturity of debt (in principle to perpetuity) should be a strategy for the medium term. If the ECB were to buy that debt, we’d have monetization.

As a side note: The macroeconomic impact of cancellation and of monetization are alike. But cancellation poses a number of (mainly political) issues. I think it is wise to take it off the table and discuss pros and cons of a permanent increase of the ECB balance sheet size. Furthermore, I do not enter into the issue of monetization vs QE (that yielded “reservization”). That issue is very neatly addressed by my colleagues Christophe Blot and Paul Hubert (in French).

The FT editorial board then goes on with a discussion of helicopter money (making a link with debt write-off that I don’t quite see, but whatever) in managing deflationary pressures; once again the verbatim is instructive:

There may be monetary reasons to cancel government debt holdings. Many economists argue that “helicopter money” — a permanent increase in the money supply, likened by the economist Milton Friedman to central bankers dropping cash from a helicopter — will be necessary to rescue the eurozone from potential deflation. This would be most easily enacted by simply writing down the ECB’s existing holdings of government debt to zero. Any move towards this policy should come from central bankers keen to hit their inflation targets and not politicians playing with populist slogans.

What is interesting is the last sentence of the paragraph: The initiative should come from the ECB in pursuing its objectives, not from governments. I made the exact same point a couple of days ago (in Italian, unfortunately). Interestingly, the strong independence of the ECB in this case could help in making the one-off nature of monetization credible and to avoid triggering expectations of fiscal dominance.

So in the end the FT editorial board case against cancellation boils down to timing and to the opportunity that politicians (especially Italians) bring it up now. But the FT acknowledges that the issue of dealing with the Covid related extra debt is on the table and that some sort of ECB sterilization of that debt may in the future be part of the equation.

I am perfectly fine with this article. In spite of the title!

Advertisement

Mr Weidmann and the Classics

Bundesbank President Jens Weidmann strikes again. In a tribune on today’s Financial Times he argues that to break the sovereign-bank nexus, the only solution is to impose, through regulation, an extra burden on sovereign debt holdings (he is gracious enough to concede that a transition period could be accorded).
I find this fascinating. Germany is the country that most opposes a fully fledged banking Union, that to be effective would require common deposit insurance, a crisis resolution mechanism, and I would add, an enhanced role of the ECB as a lender of last resort.
This would break the vicious circle between sovereigns and the financial sector, without denying the special role of banks and credit in a modern economy; nor, also relevant in today’s situation, their capacity to finance governments. Weidmann stubbornly refuses to see any specificity to banks, and has nothing else to propose than imposing by regulation what de facto is a downgrading by default of sovereign debt.
Mr Weidmann is a talented economist. He should maybe go back to Bagehot’s Lombard Street

It’s the Denominator, Stupid!

This weekend’s news was the downgrade of the UK by Moody’s. Chancellor Osborne took this as a sign that austerity should be strengthened even more, probably because he had little choice (never put all your eggs in one basket…). And yet, if only somebody in Downing Street bothered going through the text, they would have read this:

The key interrelated drivers of today’s action are:
1. The continuing weakness in the UK’s medium-term growth outlook, with a period of sluggish growth which Moody’s now expects will extend into the second half of the decade;
2. The challenges that subdued medium-term growth prospects pose to the government’s fiscal consolidation programme, which will now extend well into the next parliament;
3. And, as a consequence of the UK’s high and rising debt burden, a deterioration in the shock-absorption capacity of the government’s balance sheet, which is unlikely to reverse before 2016.

Thus, Moody’s analysts clearly state the direction of causality:

The Tree and the Forest

What to do of yesterday’s decision of the ECB? The tree looks very rather nice, the forest much less. First, a look at what Mario Draghi announced:

• “[…] the Governing Council today decided on the modalities for undertaking Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area. […] We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area. OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro. […] we act strictly within our mandate to maintain price stability over the medium term.” The technical note accompanying the decision explicitly states what markets wanted to know: “No ex ante quantitative limits are set on the size of Outright Monetary Transactions” In other words, bond purchases will be unlimited.The technical note also specifies the conditionality, the fact that the purchases will be on short maturities, and that they will be fully sterilized.
• Let’s go back to Draghi: “we decided to keep the key ECB interest rates unchanged.  […] inflation rates are expected to remain above 2% throughout 2012, to fall below that level again in the course of next year and to remain in line with price stability over the policy-relevant horizon.“

To summarize, the ECB will try to bring down the spreads, acting within its mandate, because speculation is perturbing the transmission mechanism of monetary policy and threatening stability.  This can also help explain the decision to keep the rates unchanged: there is no point in using that lever, unless it is  sure it works.

Why is the tree rather good? And what makes the forest more worrisome? The tree first.

Of Useless Summits (and Related Posts)

So, we had another crucial summit, on June 28-29, followed by another also crucial Eurogroup, on July 9. Like all the ones that preceded, and the ones that will follow, they were trumpeted as the final solution to eurozone woes. And as usual, these “final solutions” lasted days, if not hours.

I was tempted to comment immediately after, but I wanted to see the dust settle for once, so as to have more perspective. Did not work that way, though, as news kept piling up. But let’s look at what was agreed.

Spiraling

Istat, the Italian statistical office, just released its Quarterly non-financial accounts for the General Government. As were to be expected, deficit is spiraling out of control (8% on the first quarter, against 7% in 2011), because of higher borrowing costs, and because the economy is doing very poorly.

Two days ago  they released the provisional  unemployment figures for May:  stable above 10% (youth unemployment is at 36.2%!).

It seems that we come full circle, robustly installed in a Recession-Deficit-Austerity-Recession-Deficit-and-so-on spiral.

Austerity works, right?  Why on earth, should Italy aim for a balanced budget in 2013? Is this required by current European rules? No(t yet). Is this reassuring markets? No. Is this boosting private expenditure? No. Is this killing the Italian economy? Yes.

Ah, and if at least we did something for those spreads…

A Banking Union without a Fiscal Union?

I really enjoyed this piece by Perry Mehrling on the lethal embrace between sovereign debt and banks, and on how to dissolve it.  Alex Barker and George Parker on the Financial Times seem to think that the only way to have a banking union is to have a fiscal union (which makes the proposal impossible to implement). Mehrling disagrees, and explains how this could be done.

I am no expert in finance, but he seems rather convincing. And for once, here is a proposal that does not call for a grand solution (unfortunately, very unlikely), but for a step-by-step process.

Also, i really enjoy reading what happens at INET (yes, this is called advertising).

Be Smart, Borrow More!

Larry Summers has a very interesting piece on yesterday’s Financial Times.

He argues that a few countries (the US, Germany, Japan, the UK; I would also add France) enjoy extremely low borrowing rates, both short and long run. In particular, real rates (nominal rate minus inflation) are negative or zero for maturities up to 5 years, and extremely low for longer ones.  Summers’ conclusions are then straightforward:

• Focusing on further quantitative easing is not particularly useful;  given the already very low rates, further reductions are unlikely to trigger private spending (it has a name: liquidity trap. And Paul Krugman has been insisting a lot on this, for example here)
• More importantly, government should borrow now, like crazy, taking advantage of the favorable conditions to reinforce their long term fiscal sustainability. This is what any reasonable CEO would do, and there is no reason why governments should act differently.

Summers makes a point that is almost obvious: Any project that has positive expected return would improve the country’s fiscal position, if financed with debt at negative real rates: This is the time for example to borrow to buy government buildings that are currently leased. Or to accelerate the rate of  replacement of aging capital; or again, to engage in long term infrastructure building/renovation. Makes sense, right? It makes so much sense, that chances are that it will not be done…

I would like to add two considerations. The first is to stress that to get private demand started, it is important that growth perspectives are stronger. Firms today do not invest, not because of borrowing costs, but because even at very low interest rates, expected demand is so low that investment is not profitable. The second is that, for Europe, increased borrowing in Germany, France and the UK would be crucial. Countries enjoying low rates could not only significantly improve their long term prospects, as Summers argues. They could also sustain demand in countries that are consolidating, thus favoring the rebalancing I have repeatedly argued for.

Greek Tragedies

I am preparing a class on the crisis, and for the first time I have put together in a single place the actual numbers that I discussed sparsely in the past. Taken all together, they are even scarier. So scary, that I want to share them.

On Wage Reduction and the Contract Between Workers and the State

My colleague Sezgin Polat, of Galatasaray University, has an interesting idea on wages and the burden of the crisis. All the more interesting, that just yesterday the ECB called for further wage flexibility, at a moment in which aggregate demand is despairingly low in the eurozone. Here is Sezgin’s proposal (I shortened it):