The ECB is the difference

The reason Greece (and Ireland, and Portugal, and to some extent Spain) are in so much trouble is that by adopting the euro they’ve left themselves with no good way out of the aftereffects of the pre-2008 bubble. To regain competitiveness, they need massive deflation; but that deflation, in addition to involving an extended period of very high unemployment, worsens the real burden of their outstanding debt. Countries that still have their own currencies don’t face the same problems.

The Euro Straitjacket, Paul Krugman

As I told Brian Milner of the Globe & Mail:

The euro area has become the focus of the sovereign debt crisis, rather than the U.S., Britain or Japan – all of which have huge deficits of their own – because of the currency zone’s faulty design… While 17 countries share the common currency, there is no central fiscal authority or executive body capable of enforcing rules or addressing the vastly different levels of competitiveness within the region.

Here’s the thing though. The ECB does have the power to end this. They are not doing so for ideological reasons. Let me suggest two scenarios.

The ECB could do rate easing. Frankly, I am uncomfortable with any kind of easing but I certainly see some legitimacy in the ECB acting as a lender of last resort here. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a Bagehot penalty spread to Bunds but low enough that it effectively acts as a lower bound for a positive nominal GDP target. This would be liquidity at a penalty rate, say 200 bps to German Bunds, which would be 4.7% right now.

In practice the ECB would want to step in at unpredictable times and buy up sovereign issues below the guarantee rate to ‘punish’ speculators and police the guarantee this way.


you could have sovereigns conduct a ‘sovereign debt swap’ whereby the ECB buys an agreed-upon portion of the existing debt from the sovereigns and then uses these funds to back the [Eurobond] supranational debt. In future, the same agreed upon percentage of debt would be issued at the supranational level. Clearly, you have to have all euro zone members commit in equal measure or the benefits would not accrue to the periphery.

I reckon a proposal of this sort would be controversial. One should consider this a form of quantitative easing. This is the sort of structure which could only be set up over time – and may require amendments to existing treaties. Moreover, it should be viewed as a move toward the United States of Europe. I have said previously that the Germans would rather defect than allow this. So it will not be considered a legitimate political option until all other more superficial remedies have failed.

Eurobonds are a potential facet of European sovereign debt monetisation, Nov 2010

  1. Philip AD Secretan says

    Assuming that this slow motion train crash is partly alleviated by some centralisation of fiscal and other powers, how will the French and Germans take to the loss of national power and identity to the centre that they will suffer as a result?

  2. David Lazarus says

    A lot of this ignores the fundamental problem of german banks exporting the fiscal surpluses of the german exporters. If there had been credit controls Germany would have been flooded with money and the PIGS would have had to deal with their fiscal problems earlier. It would have also eliminated the contagion problem.

    1. Edward Harrison says

      Agreed, David. You need structural reform for the eurozone to work. Monetisation and defaults might alleviate liquidity concerns, but longer-term you need fiscal union and/or pre-funded transfer mechanisms.

    2. Positroll says

      One major reason for that was the European Commission during the naughties forcing the German Landesbanken to switch from their old model (doing boring lending in their home state at low rates while being backstopped by the public) to act like “normal” banks. Result: they had to chase yield and started investing German money in the PIGS and (now worthless) US papers.
      So while the EU Commission defended “free competition” (yeah, right, because Germany would never bail out private banks, would it … ?) it reduced German growth while artificially inflating the PIGS and making the Landesbanken very vulnerable. Thanks a bunch.
      And now the IMF is continuing this B.S. by stating that the Sparkassen – though they were the one anchor of stability during the GFC – should be privatized, too, all in the name of liberalisation of markets. Don’t these guys ever use their brains ???

  3. Romeo Fayette says

    This sidesteps the central issue with the entire EMU: the political will for fiscal/political consolidation, not to mention the explicit “bailout” prohibition (which the ECB has reluctantly ignored).
    What’s more than that: you cannot manipulate a market for the long-term. See Black Wednesday, Asian Crisis, etc. Trading bands and price ceilings are broken if the market’s equilibrium belongs beyond the line.

    1. Edward Harrison says

      Agreed. Same comment as I gave to David. This only has to do with liquidity. But the Europeans have to deal with all three problems, liquidity, solvency and structure.

      1. Romeo Fayette says

        Italy has $88B to roll in public debt this year. That’s a lot, but not as much as the $190B next year. I understand your thinking there.
        There are questions the ECB has to ask itself. First, they can tear up their charter and proceed with more bond buying or even a ECB bond issuance (not a far cry from EFSF). That’s probably necessary for the monetary union.
        Also, if they want to cap rates on Italian sovereign bonds, do they have the liquidity to back the entire bloc if vigilantes move to other memberstates.
        M1=EUR4.69T; Official Reserves=USD319.5B
        Italian Gross External Debt=EUR813B
        That’s a big gamble, particularly when you consider the thin asset base of the ECB (no tax revenues other than membership royalties)… but such is fiat I suppose.

        Love your work Ed. Keep asking the tough questions and working with tough answers.

        1. Edward Harrison says

          Thank, Romeo. I am with you there. The ECB is having the same problem the Fed had in 2008 in buying up dodgy paper at favorable rates to support clearly insolvent debtors. That certainly will ‘solve’ the liquidity crisis but it is a clear extend and pretend strategy. And eventually you have to socialise all the losses before the next downturn or extend and pretend fails.

          1. David Lazarus says

            The problem with socialising the losses is that it destroys the nations balance sheet. Look at Ireland. It would be doing so much better if it had allowed its banks to collapse and forcing bondholders and shareholders to take losses. The extend and pretend cycle is nearing its end, but I cannot see the politicians in Europe getting away with bailout out their banks at the expense of the tax payer.

          2. Positroll says

            1) There is only one way to “socialice” the losses that I think would be acceptable for German voters: A general money drop.

            a) Phase 1:
            ECB buys up PIGS debt on the open market at a discount.

            b) Phase 2:
            ECB creates money out of the blue and distribute it on a pro-capita base to all member states. WRT to those EMU – countries that have debt > the 60% criterium, the ECB would use the money to finance the earlier buy up of their securities.

            c) Result: more money in the system, but no direct effect on inflation in the real economy. German politicians still won’t like it too much, but it helps them by reducing the need for high taxes. Germany might add a tax rebate for those consumers who have a big part of their money invested in a long term life insurance contract (would be hit hardest by inflation in the long run) …

            2) In addition, the EU structural + agricultural fonds could be increased and be joined by a fonds to fund European energy projects bringing solar power from the med to Germany.

            3) Germany should give its taxpayers a tax rebate if they travel to the PIGS countires out of season. Say 50% of the hotel bill up to 300 EUR / year. Nice little present for German taxpayers (good for elections …) that doesn’t increase inflation in Germany and helps the PIGS economies. Also, Germans who traveled to these countries might be somewhat more inclined to allow a little more solidarity payments to happen …

            There is other stuff like that that Germany could do, but it would require Mrs Merkel to become proactive, something she somehow doesn’t like …

          3. Edward Harrison says

            A helicopter drop! You know that large part of German voters would revolt if the ECB did a helicopter drop. In the end I agree that Merkel will stay in reactive mode and we will just have to live with this deteriorating situation until it reaches its end phase.

  4. Positroll says

    “You know that large part of German voters would revolt if the ECB did a helicopter drop.”
    Don’t think so,
    – if it is agreed + made clear that it is a one time event (next time, the PIIGS will be on their own) and after that, the ECB will keep core inflation below 2,5% short term and below 2,5% mid term
    – since it will not be really inflationary, see above
    – since German citizens will themselves profit from it (less German debt => lower interest rates => less taxes), unlike the current situation / proposals where only the Greeks and the German banks are bailed out.

  5. Positroll says

    that’s supposed to mean “below 2,0% midterm”

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