Rogoff sees ECB monetisation followed by recapitalisation or seigniorage and currency depreciation
Everyone is focused on the narrow issue of whether Greece can be cowed into austerity-induced depression and whether they will hold a referendum, default or leave the euro zone. There are bigger existential issues. Harvard Economist Kenneth Rogoff has a post up at Project Syndicate which does a good job in laying out the core conundrum that Europe faces in the sovereign debt crisis. He theme is exchange rates and currency revulsion. But the underlying framework Rogoff presents is anchored in a presentation of debt and monetary policy issues that is similar to what you read at Credit Writedowns.
His basic points are as follows:
- The October 26th “comprehensive package” for Greece will not hold up because it is inadequate. It is a gimmicked hodge-podge of vague promises which do not cut the sovereign debt levels in Greece nearly enough to put the country on a sustainable fiscal path.
- This so-called solution is all the more inadequate because Euroland would need a tighter fiscal union if it is to avoid the kind of liquidity crisis it is now experiencing. As this is something that requires constitutional changes which take time, “it seems clear that the European Central Bank will be forced to buy far greater quantities of eurozone sovereign (junk) bonds.”
- “That may work in the short term” but eventually “the ECB will in turn have to be recapitalized. And, if the stronger northern eurozone countries are unwilling to digest this transfer – and political resistance runs high – the ECB may be forced to recapitalize itself through money creation.”
I would quibble with bits of his analysis, like the part where he says that sovereign default risks will again likely materialise. The default risk is a lender of last resort risk. Here’s how I put it last month when discussing currency revulsion:
In the euro zone, the governments are not monetarily sovereign (like states in the US) and have only an implicit backstop from the ECB (akin to Fannie and Freddie). So, rightfully people are tacking a default premium onto the term structure. Germany has almost zero default risk. France has slightly more. Spain and Italy have even more.Greece has nearly 100% default risk. That means there is enough doubt about whether the ‘independent’ ECB stands at the ready to backstop the French sovereign to cause French spreads to German Bunds to increase.
Notice that the macro debt fundamentals of France are worse than Spain’s (higher debt to GDP and deficits since the euro began and higher present debt to GDP and same large budget deficit). Yet spreads are much lower. That tells me that France has a perceived backstop that Spain does not. If the ECB credibly committed to ‘monetising’ deficits as the Fed has done, yields would immediately fall to reflect the diminished default risk. The ECB has not done so because this backstop would create currency revulsion and weaken the euro.
So let’s be clear here. If the ECB were like the Fed and it was backstopping a central European treasury that emitted Eurobonds, there would be no problem in Euroland. In fact, the Europeans could run government debts up to 200% of GDP like the Japanese without currency revulsion or spiking interest rates – not that they should want to, but they could. But, that’s not the institutional structure in Euroland, so they can’t do that and so they are exposed to currency revulsion and rates are spiking.
There’s a further problem.
The failure to sort out the ambiguities concerning the distribution of the fiscal burden that may arise through bail-outs of banks operating in multiple Euro Area nation states puts a large question mark behind the effectiveness of the Euro Area financial stability arrangements. The Euro Area has proven itself to be capable of handling a banking sector liquidity crisis. The institutional arrangements, including the fiscal burden sharing key, for handling a banking sector insolvency crisis are opaque at best, non-existent at worst.
We must know who would recapitalise the ECB should it suffer a material capital loss, and through what mechanism this would occur.
–Willem Buiter, May 2008
If the “stronger northern eurozone countries,” as Rogoff puts it, did not stand at the ready to recapitalise the ECB, then the ECB would have to print money and allow seigniorage to work it out of its insolvency. As long as the ECB stays clear of loading itself up with dollar swap liabilities with the Fed, it can just print money and eventually the seigniorage from that money printing will recapitalise the ECB.
The problem, of course, is currency revulsion. As soon as the ECB starts printing money like crazy to work its way out of the insolvency it created by buying duff Greek and Portuguese assets off the Belgian, French and German banks desperate to unload the stuff, people will flee euro assets like the wind. You want price instability aka currency revulsion, well there you go.
In sum, the present 50% haircut for private creditors only is never going to work. More writedowns are coming. Everyone knows this and so the sovereign debt crisis continues unabated. In fact, it is worse. Because the Europeans have what Rogoff calls a “halfway house” between full fiscal integration and national currency sovereignty, the crisis can only be tamped down by the ECB monetising periphery debt.
But, of course, that presents a solvency issue for the central bank. If countries remain intransigent, the ECB will print money and the euro will have a serious gravity test and fall like a stone, inflation will climb, and you will see the mother of all competitive currency devaluations thereafter. on the other hand, if the Europeans care about price stability at all, which the Germans, the Dutch, and the Austrians et al do, then they’re going to fork over a wad of cash to top up the ECB’s capital base on a pro-rata basis – end of story.
Bottom Line: The ECB will monetise and the Europeans will top it up with capital. That is how this is going to play out.
Source: A Gravity Test for the Euro – Kenneth Rogoff, Project Syndicate