Some euros are more equal than others

John Kay on the inherent flaw in the single currency once a route to euro exit is created for peripheral countries:

The growth of indebtedness of the weak euro currencies to the strong has already happened and is continuing. When Europe’s leaders claim the continent is now better placed to withstand a crisis they mean only that this accumulation has been largely transferred from the private to the public sector, mainly the European Central Bank. Since there is potentially no limit to the willingness of the private sector to exchange weak euros for strong, the only limit to the process is the patience of German and Finnish taxpayers. So check whether the euros you hold are eagles or owls before others do.

I don’t expect the Germans would call time on the euro. It would be too destructive and would trash the country’s reputation for decades. (Though they’re willing to engage in brinksmanship, with suggestions they may have considered voting against allowing the Bank of Greece to do ELA for its banks – the only mechanism I can think of, assuming they could convince two-thirds of the 23 ECB council members to back them, to actually force a country out of the euro.)

But as I’ve said before – and as Wolfgang Münchau argued earlier this week – you don’t need a Rubicon-crossing initial euro exit for this to happen; only a continuing asymmetry between a continental currency and national deposit guarantee and bank resolution authorities.

This is the immediate problem Europe needs to fix.

How the Bank stole the recovery! (part 1)

I flagged earlier that I wanted to explore some reasons why quantitative easing (QE) hasn’t succeeded in prompting a broader recovery in the UK.

To start off with, let’s think about how QE is supposed to work. There are a number of possible transmission channels – for instance, I took the following diagram from the Bank of England’s Q3 2011 Quarterly Bulletin:

However, I want to focus on a transmission channel that the Bank (given its 2%-inflation mandate) has been relatively quiet about – the impact of QE through nominal variables. I’m happy to be agnostic for now about exactly how this channel is supposed to work, but there are two broad sets of ideas:

• Keynesians / New Keynesians (such as Paul Krugman) often emphasise the importance of real interest rates in a deflationary environment. Given that nominal interest rates cannot go below zero, a sufficiently-positive rate of inflation is required to achieve the negative real interest rate that a depressed economy might need in order to recover.
• Market monetarists (such as Scott Sumner) focus on nominal spending as the determinant of aggregate demand. In this view, a central bank can always increase nominal spending by debasing the currency; and, at times when the economy isn’t supply-constrained, growth in nominal GDP (NGDP) is a precondition for growth in real GDP.

Whichever of these views you might hold though, it’s clear that the ability of the central bank to act in an inflationary manner is crucial. In the New Keynesian view, you need to increase inflation expectations so as to reduce real interest rates (since r = i – π^e). In the market monetarist view, you need to increase expectations of nominal spending, of which inflation expectations are a component. Either way, to use Krugman’s phrase, the central bank needs to ‘credibly promise to be irresponsible’.

Let’s see how that’s working out for the Bank:

Looking at the 5-year average inflation rates implied by market prices, we can see that QE and a rise in inflation expectations during 2009 did occur together. But also that: (a) inflation expectations started rising from their post-Lehman trough two months before QE started; and (b) more crucially, inflation expectations merely returned to their pre-crisis range of 2-3%, rather than the ‘irresponsible’ levels a central bank might need to target to reduce real interest rates / boost nominal spending, as a depressed economy might require.

Partly, the Bank’s failure to be credibly inflationary is the flip side of the successful introduction of inflation targeting in the UK in the 1990s. People don’t believe that a central bank legally committed to achieving 2% inflation is likely to let prices get substantially ahead of that.

But to some extent, this is also due to the Bank actively telling people that it won’t ‘irresponsibly’ allow QE to be inflationary – even though allowing QE to be inflationary may be crucial to allowing QE to succeed! Here’s Mervyn King at the Treasury Select Committee in February of this year (my bold):

I think actually unwinding [QE] is one of the more straightforward aspects. Either we would sell the gilts that we had purchased back on to the market or if we felt we were putting too many gilts on the market at the same time, or in a short period, we could issue short-term securities, Bank of England bills, and sell those. Actually mopping up the liquidity is a relatively straightforward aspect of this process. I am in no doubt that if we felt the need to unwind the economic effects of asset purchases, it would be a lot easier to slow the economy down when we come to unwind it than it is now to try to encourage growth in the economy by conducting asset purchases. I think going the other way would be a lot easier than trying to stimulate the economy at present.

So what he’s telling people, very clearly, is that the Bank is willing and able to unwind the large increase in the monetary base. In other words, the Bank views QE as a temporary increase in the monetary base – but then why should people assume it will have a permanent effect on the future price level? The Bank is not credibly promising to be inflationary.

This is why I’m increasingly attracted to targeting the level of NGDP, rather than the annual rate of inflation. If we can get the Bank to credibly commit to a future path for the level of NGDP in each of the next few years – with a legal mandate for the MPC to hit that path, irrelevant of what that means for inflation – then I think we’d go a long way to addressing the demand deficiency we’re experiencing. Either nominal spending does drive real spending, in which case hitting the NGDP target leads to real growth too; or nominal spending doesn’t directly drive real spending, in which case hitting the NGDP target means price inflation, which reduces real interest rates and in turn does drive real growth.

But in the meantime, the Bank still has a 2% inflation target – which the market believes it can maintain, in spite of QE, because the Bank is telling everyone that QE will be unwound in the future.

So no wonder all that QE doesn’t seem to have done much for us yet!

Chart of the week: 14-20 May 2012

I’ve taken this week’s from the Bank of England’s latest Inflation Report.

In spite of unprecedented monetary stimulus, the Bank still expects CPI inflation to actually undershoot the 2% target in the next few years. I’ve previously suggested that this is because the Bank’s approach to quantitative easing has focussed on buying assets that are close substitutes for monetary base – which may have contributed to a lack of feed-through into broad money.

But other factors could also be at play – and I want to explore some of these in the next few days.

Greece is not real (it’s nominal)

I enjoyed this post from Scott Sumner:

This tiny country is 2% of the EU.  If (God forbid) it was destroyed by an asteroid tomorrow, stock markets would soar upward all over the world.  The Greek crisis would be over.  Yes, banks would hold some worthless Greek debt; but with no further moral hazard concerns, the rest of the eurozone would gladly bail out their banks, and add that Greek debt to their own public debts.  Remember, Greece is 2% of the EU.

Why would stocks soar on the destruction of Greece?  Because it would end the uncertainty, the fear that a Greek departure from the euro would have a contagion effect.  People who talk about structural problems talk about things like malinvestment in too many houses or BestBuy stores, or Obama’s big government policies, etc.  But the markets don’t care very much about those things; they care about things like Greece.  And not because Greece is big enough to have a real effect on the global economy, obviously it isn’t.  Rather Greece matters because it could trigger a financial panic that would reduce AD [aggregate demand] all over the world.  That’s why global equity markets lose TRILLIONS of dollars when the Greek crisis intensifies.  The real problem is nominal.

Everywhere I look I see more and more evidence that the developed world has a massive AD problem.  Yes, individual countries (southern Europe, to a lesser extent the UK, and to a still lesser extent the US) also have some structural problems.  But the NGDP problem is both easy to fix and a big part of what’s hurting the world economy.  It’s frustrating to see us ignoring it.

It’s now far too big a problem to be addressed by any token fiscal stimulus that could come out of this recent Camp David push for “growth.”  Monetary policy is our only hope.

Would a Greek default immediately lead to a euro exit? No.

A lot of the discussion of the Greek elections has focussed on the strong performance of anti-programme parties such as Syriza (17% on 6 May), Independent Greeks (11%), the Communist Party (8%), Golden Dawn (7%) and Democratic Left (6%) – and their expected further gains (particularly Syriza) on 17 June. This is what’s prompted the fears of an imminent exit. But would an anti-programme government necessarily mean a euro exit?

I can see two parts to this question. Firstly, is there a political incentive for a newly-elected anti-programme government to exit the euro? And secondly, is there an economic transmission mechanism whereby a disorderly sovereign default rapidly forces Greece out of the euro? I’m thinking only about short-term events here – i.e. if a default happens shortly after 17 June, would a Greek euro exit be announced within the next few weeks?

On the political point – anti-programme parties are on the rise, but polls show most Greeks (c.80%!) remain pro-euro. And most votes on 6 May went to pro-euro parties: of the seven parties that made it into parliament, only the two most extreme – the Communists and Golden Dawn – are explicitly anti-euro.

One or more of the anti-programme parties could form a government after 17 June. If they stick to their pledges, this would lead to a drying up of EFSF/IMF loan tranches, an inability to meet Greece’s bond maturities and interest payments as they fall due, and a need to balance the budget overnight to make up for the lack of external funding.

But these parties aren’t yet arguing for Greece to then leave the euro at that point. Indeed, you can imagine that short-term political incentives would make them even less wiling to agree to a euro exit once they’ve formed a government.

The first move in a euro exit would be to freeze bank deposit withdrawals, which would no doubt irk voters; the final move is the actual devaluation, reducing the purchasing power of those very same voters. If you think the Greeks are rioting over austerity, wait to see what they do when their government does these things to them. Meanwhile, all those other anti-programme pro-euro parties outside the government would be going for the jugular, lamenting the prime minister’s awful decision to impose this unnecessary additional hardship on the voters when all they really wanted was someone who could go to Brussels and Frankfurt and negotiate a different deal. There is not, therefore, an obvious political reason why a euro exit would quickly follow on from a sovereign default.

So I therefore wonder: is there an economic reason?

Martin Wolf gave one view in today’s FT:

[…] a cessation of external official funding could trigger a disorderly collapse. The government would default. The European Central Bank would argue that Greek banks no longer possess good collateral, which would prevent it from operating as a lender of last resort. There would be comprehensive bank runs. Athens would impose exchange controls, introduce a new currency, redenominate domestic contracts and default on external contracts denominated in euros.

In Wolf’s scenario, it’s the collapse of the banks that forces Greece to exit. I can certainly envisage such a channel:

• lack of central-bank funds would lead to a system-wide bank run, as depositors try to get their cash out before the banks collapse;
• euros would now be hoarded under mattresses or outside the country, out of fears over bank solvency and redenomination respectively;
• ultimately forcing the government to introduce a new currency just so that ordinary day-to-day transactions can actually take place in Greece.

Yet crucially, I think Wolf is mistaken in suggesting that all central-bank funding would be cut off at the point of a sovereign default. Yes, the Greek banks would no longer be able to use their defaulted Greek government bonds (GGBs) to access ECB facilities; but would they not just turn to Bank of Greece ELA as an alternative? They’ve done this once already, in March/April, when their GGBs briefly became ineligible for ECB operations after the PSI and so they moved them all over to Bank of Greece facilities. And there doesn’t seem to be a constraint on ELA – the Irish did €100bn of it, after all.

Anyway, if the Bank of Greece can continue funding the Greek banks after a sovereign default, I don’t think there’s the same obvious short-term mechanism that will force Greece out of the euro. This isn’t to say that there aren’t other things happening: as I said the other day, central-bank-addicted ‘zombie banks’ don’t default, but they also don’t lend, so the medium-term outlook for Greece would remain fairly grim.

But the point I’m trying to make is that a Greek default soon after 17 June doesn’t necessarily mean a Greek euro exit will immediately follow. Greece could exist in a kind of limbo for while. Indeed – there could be many months between a disorderly sovereign default and an eventual euro exit!

And during that lengthy interlude, could we be hopeful that cooler heads might prevail?

Bank runs in the periphery: why they matter and how to stop them

Lots of attention over the last few days on deposit outflows from Greek banks, an acceleration of the slow-motion bank run of the last two-and-a-half years that saw €95bn of deposits leave the country’s banks between September 2009 and March 2012 (i.e. more than one-third of Greek banks’ peak €282bn stock of deposits).

In spite of the deposit flight, the Greek banks have continued to fund themselves through ECB/ELA facilities. So why exactly does this matter?

Tyler Cowen explained the point well in this article looking at similar deposit outflows from the Irish banks:

This flight of capital reflects a centuries-old economic principle known as Gresham’s Law, sometimes expressed casually as “bad money drives out good money.” In this context, if two assets — euros inside and outside Ireland — are not equal in value in the eyes of the marketplace, sooner or later the legally fixed price parity will fall apart.

If enough depositors fear frozen accounts, the banks will be emptied out, and they also will require additional government bailouts, on top of the bailouts for the bad real estate loans. The banks come to resemble empty shells, conduits for public aid but shrinking and unprofitable as businesses — and, to a large extent, that is already the case in Ireland. Portugal is moving in this same direction, toward being a land inhabited by zombie banks.

Essentially, if you think about bank deposits as distinct financial assets, it becomes clear that the value you would place on a euro held in a bank with a low risk of default is different to that of a euro held in a bank with a high risk of default. But as there’s a fixed legal parity between the price of a euro in the two banks, which prevents prices adjusting, the quantity takes the full brunt of the adjustment instead:

Within a currency union, this problem is usually solved through bank deposit guarantees. We’re content to treat sterling deposits in HSBC, RBS or Manchester Building Society as equivalent assets, despite the very different business models of these banks, because the UK Financial Services Compensation Scheme (FSCS) stands behind their retail deposits (at least up to a limit) – and the UK government ultimately stands behind the FSCS.

But within the euro area, deposits guarantees are still done on a national basis. Deposits in German banks are guaranteed by the German authorities and deposits in Greek banks by the Greek authorities. And the German deposit guarantee is patently going to be more creditable than the Greek scheme –  particularly once euro exit concerns are brought into play.

The pre-crisis assumption that bank deposits in different parts of the euro area were equivalent was therefore clearly as misguided as the assumption that different euro area governments had the same (low) credit risk. And, as with credit risk on euro area governments, I don’t see how investors will ever go back to the old assumption unless there is a fundamental change to the structure of euro area banking.

Alongside some form of eventual fiscal union, I therefore think the euro area will need to introduce a form of mutualised deposit guarantee as a necessary condition for preventing a future crisis once this one is over. Indeed, it may even be a necessary condition for ending the current crisis, given the lending and growth implications for Europe of this breakdown of the monetary system. Returning to Tyler Cowen:

It’s the zombie banks that doom the current European bailout plans. On any single day, or even for a year or two, an economy can survive with zombie banks, but over time functional domestic banks are needed to allocate credit.

If they don’t find a way to return to a situation were euros in German banks and periphery banks are valued equally, deposit flight and the consequent dearth of credit will continue – and bang would go hopes for Spain.

Yes, sovereign currency issuers can always be ‘solvent’ – but don’t be so damned blasé about it

This video on New Economic Perspectives explains the view of modern monetary theorists (MMTers) that a ‘monetary sovereign’ – i.e. one with its own domestically-controlled currency, like the UK or US, rather than a country in the euro area – does not face financial constraints and therefore cannot be forced to default on domestic-currency debts.

I’ve heard this view expressed a number of times to explain why either: (a) the ratings agencies are stupid to downgrade the debts of countries like the US;  (b) governments of sovereign currency issuers are stupid to pursue fiscal consolidation in countries like the UK; or (c) euro members are stupid to have foregone monetary sovereignty by joining the single currency.

The argument behind this is incredibly simple. It goes like this.

(1) Monetary sovereign governments in advanced economies spend, tax and borrow primarily in their own domestic currency.

(2) Their domestic currency can be created at will by their central bank, which these governments can control through legislation.

(3) These central banks have made no legal commitment to maintain the value of their currencies against any other currency or physical commodity – i.e. these are floating, fiat currencies.

(4) Therefore, if a government is ever unable to sell its bonds privately, it can always change the law and force the central bank to create new domestic currency to fund a deficit.

So sovereign currency issuers are always ‘solvent’, in terms of being able to make any debt and interest payments to bondholders in nominal terms, simply by forcing the central bank to buy up the new issuance required to fund these payments.

There is nothing profound about this. It just says that, if all else fails, you can monetise your deficit.

I cannot believe that this is put forward as a serious or practical policy argument.

I am all in favour of the ECB doing what’s needed to prevent continent-wide contagion from a Greek exit, including temporarily backstopping sovereigns. But governments should still do whatever it takes to avoid getting to the awful point of commandeering the central bank to avoid a certain default. And once there, they should do whatever it takes to get off monetary financing, as quickly as humanly possible.

Deflation can be brutal. Today’s Americans learn this from their country’s inter-war history.

Hyperinflation can be so much worse. Today’s Europeans learn this from Europe’s own inter-war history and its bloody, savage, senseless aftermath.

Yes, a sovereign currency can always turn to the printing press to prevent a default. And in extremis, once you’ve reached the point of ‘monetise or default’, monetisation may be the best of a bad set of options.

But don’t ever forget the horrors wrought on their citizens by governments that became addicted to the printing press.  And don’t be so damned blasé about it.

The first days of the Greek exit

Given widespread discussion of a possible imminent Grexit (aka ‘Greek exit’) – including by some European officials – it’s worth briefly sketching out what it would look like.

In terms of actually introducing a new currency, I think this is a massive logistical challenge that would take months – just in terms of printing notes, distributing them, reprogramming ATMs, etc, let alone the legal quagmire. But in the immediate aftermath of the decision, I would expect all of the following three things from Greek and European leaders:

(1) Greece would pass emergency legislation introducing capital controls and creating the new currency in legal (if not yet physical) form. This would unilaterally violate the Maastricht Treaty, which provides for free movement of capital between EU members. The widely-expressed legal view is that there isn’t a legal mechanism for quitting the euro, unlike for quitting the EU – so this Maastricht violation might be the first step towards an EU exit and consequent application to rejoin the EU or EEA post-Grexit.

(2) The New Drachma would start trading at a shadow exchange rate, even before it exists physically. The currency would no doubt depreciate heavily against the euro.

(3) The institutions of the euro area would have to announce, immediately, a massive extension of support to the remaining periphery. There’s been a lot of talk – e.g. from the Dutch finance minister today – about the ‘firewall’ Europe has put up since the start of the crisis. This counts for absolutely nothing: if you’re a depositor or investor in Portugal/Ireland/Spain/Italy and you see Greece exiting and people with money in Greece frozen there by the overnight imposition of capital controls – in spite of two years of protestations that there will be no Grexit – then the rational thing to do would be to pull your cash immediately and ask questions later. In the short term, the policy response would have to include:

• a clear public announcement by the ECB that they’re willing for banks in the remaining periphery to become reliant on central bank cash on whole different scale to what we’re used to (as a result of depositor flight and wholesale funding freezes), including larger banks there, and probably as part of a jointly-guaranteed Eurosystem scheme (which means loosening Eurosystem collateral standards) rather than nationally-guaranteed ELA funds;
• pre-approved second EFSF programmes for Portugal and Ireland to ensure their funding (if required) through to late in the decade and precautionary credit lines for Spain and Italy; and
• perhaps most controversially, some sort of explicit commitment by the ECB to deploying its balance sheet to support any euro area sovereigns that need it, either through: (i) an explicit cap on secondary market yields for euro area states; or (ii) giving the EFSF a banking license and letting it borrow as needed to fund euro area states.

None of this sounds pleasant. But they’d have to act like this after a Grexit because the consequences of not acting would be too catastrophic – and I’d bet in this situation (and here’s sticking my head out…) that the imminent continent-wide economic catastrophe and consequent changing electoral arithmetic would lead even the Germans to sign up to this programme.

I think Greece could leave. But if this doesn’t jolt the institutions of the euro area into belated action, nothing would.

Chart of the week: 7-13 May 2012

This week’s chart of the week (actually, charts) looks at the Bank of England’s decision to pause its government bond purchases (i.e. quantitative easing) at the current level of £325bn.

Ostensibly, policymakers are worried about prices. CPI inflation currently stands at 3.5%, above the Bank’s 2% target. But in spite of the Bank’s asset purchases, which have increased the monetary base by nearly 300% since March 2009, there is no evidence that this is feeding through to broader monetary aggregates. Indeed, M4 (broad money) has been shrinking since late 2010 – and at an accelerating rate!

Why the discrepancy between QE and falling M4? Because the money multiplier has collapsed, from more than 20 pre-crisis to 7.8 in March 2012. So all this extra monetary base the Bank is creating hasn’t fed through the broader money supply.

It’s therefore questionable that the QE measures up until now are inflationary. Rather, if policymakers want to affect broader monetary aggregates like M4, they’d have to go further up the risk spectrum than they’ve done so far, buying private assets that are less obvious substitutes for monetary base – and hence more likely to feed through to broad money.

To QE or not to QE…

The Bank of England’s MPC decided today to leave the stock of quantitative easing at its current level of £325bn.

Gavyn Davies attributes their decision to a recognition that the supply side of the UK economy has underperfomed – suggested by the troubling fact that inflation expectations for 2012 have risen even as growth expectations have worsened:

A few thoughts on this:

1) The inflation-vs-growth chart is compelling, but I don’t fully buy the argument that we’re near the limits of what demand can do. The 2008-09 crisis may have had hysteresis effect on potential output, plus  pre-crisis growth rates may have reflected the bubble economy rather than being sustainable – but do we genuinely think all this is enough to leave real GDP today almost 13% lower than it would have been had growth continued on its pre-crisis trend? (Perhaps the answer is yes; but what’s the evidence?)

2) Even if you’re concerned that supply-side weaknesses could lead to more inflation – are the MPC really worried that QE is inflationary? Remember, the Bank of England’s asset purchases involving buying UK gilts – highly-liquid AAA-rated government bonds – or exactly the type of security that the shadow banking sector considers to be part of its (unmeasured) ‘reserves’ on the Singh/Stella basis. CPI inflation may be currently above the 2% target, but it’s hard to argue this a result of monetary factors. Indeed, broader measures of the money supply are falling in the UK: M4 growth in March 2012 was -4.5% yoy.

3) Finally, whilst it’s strictly outside the MPC’s mandate – could the UK not chose to tolerate a bit more inflation over the next few years than we were accustomed to pre-crisis? At least some above-trend nominal GDP growth seems to be a necessary condition for smoothing the process of public- and private-sector deleveraging over the next few years.

Overall then, a disappointing decision. We probably don’t just need more QE, but also purchases of a much wider range of assets by the central bank.