I am off again this week and doing short duty on the blog. But I want to say a few words about the ECB and its impending monetisation plans given Mario Draghi’s decision to pull out of the Jackson Hole event sponsored by the Kansas City Fed. The FT has a good article outlining the variables which will influence those decisions. The key sticking points they outline are the following:
- Convertibility or redenomination risk: this is the risk that Joerg Asmussen used as a premise for ECB intervention in his interview with the Frankfurter Rundschau last week. The thinking is that spreads have widened unacceptably in countries like Spain and Italy only because of redenomination risk. For example, the IMF reckons that the fundamentals in Spain and Italy would warrant spreads 200 basis points lower than where they have traded this year. The point of intervention is to eliminate the concept in the marketplace that Spain and Italy would ever leave the common currency and thus reduce spreads. How exactly to do this is the issue at present.
- Intervention limit: Based on the desire to reduce redenomination risk and to leave the others in place, the question is what limits the ECB should place on intervention. There are two related issues. First, the SMP that the ECB used earlier to keep bonds spreads in check was limited in size and done on a very ad hoc basis. This created a politically-charged atmosphere in which some accused the ECB of exceeding its mandate. Yet, the ECB believes that an “unlimited” purchase option would actually be more effective as Asmussen said in his Frankfurter Rundschau interview because it would imply to the market that the ECB would not stop intervening until it met some undefined targets.
- Explicit yield caps: The next issue then is what those targets should be. How will the ECB know that it has been successful and therefore not need to intervene? The first and most likely choice is to have an unspoken target range for the spread on specific bond maturities for various countries. The ECB would intervene until yields are within that range only explicitly telling the market ex-post when it has met its target. The second and in my view more effective way to do this is to set (a) explicit target(s) and communicate (it/)them from the outset. If the ECB were credible, it would have to intervene much less if at all than in the hidden target variant.
- Absolute yield or spread targets: If the rationale for intervention is to reduce convertibility risk, meaning that the ECB wants to eliminate only one type of “illegitimate” risk while leaving in place the other “legitimate” risks, it will need to allow market mechanisms to keep the other risks in place. That means that absolute yield targets are inappropriate for the ECB’s stated purpose. An absolute yield target is entirely centrally-planned way of setting rates that is therefore not market-based at all. It means that the ECB would be setting yield targets for euro zone sovereign debt further out the curve in exactly the same way it sets rates for the policy target. And that is not at all a market-based setting mechanism that allows one to discretely eliminate convertibility risk.
- Conditionality: While the ECB will arguably become a fiscal tool by setting conditionality, the word is that this is what it plans to do. Yanis Varoufakis has written that this is in violation of the ECB’s mandate as it would have the ECB, a monetary agent, explicitly enforcing fiscal rules for access to liquidity for sovereigns. I have argued that the appropriate role for the ECB is as a bank lender of last resort and that this is not a sovereign fiscal operation. As such, the ECB should see this as setting an orderly market for a principal source of euro bank collateral rather than as a means to enforce fiscal discipline. In my view, conditionality for proving liquidity politicizes the ECB more than any other development since the beginning of the crisis. But the worry is that without setting conditionality, the ECB would be allowing a moral hazard for sovereign debtors. A better approach is to use a Bagehot rule that sets an explicit target above the desired yield target that is in alignment with the fiscal fundamentals of the sovereign debtor. See my post “The ECB’s Bagehot Rule Policy“. My assumption is that the ECB is not doing this in part because it want s to secretly recapitalize euro banks through this monetization and also because it wants to avoid setting an explicit yield target that it must communicate to the market.
- Maturity: The ECB must also decide what maturities it is most concerned with. Ostensibly, it could set a target for debt out to three years without having to buy maturities further out the curve because this gives sovereigns the ability to turn around their fundamentals in the allotted three year span that a Troika memorandum of understanding would envisage. The ECB would then be able to buy in potentially unlimited quantities during that entire period and hold to maturity. So the point is to have the Troika set a fiscal plan and to have that plan be backed by ECB and ESM liquidity rather than just ESM loans. The advantage here is that it means unlimited amounts of money available to fund a “bailout” of any sovereign, including Spain and Italy. This is an important point to recognize.
- Seniority: Ostensibly, the ECB’s presence would be a boon to bond buyers because it represents “free money” in the form of an ECB put that prevents default. However, the big problem for actual ECB purchases right now is that the ECB and the Troika have been deemed senior to private bondholders in the Greek restructuring. The ECB and the Troika were not forced to take writedowns while private bondholders were. This means that in other potential euro zone sovereign defaults, the more the ECB buys the less senior the debt is that private bondholders already hold. The upshot of this is that ECB purchases have a perverse effect of drying out private investors because those investors fear more loss in the event of restructuring as the ECB buys more. So, because of seniority concerns, the only stable equilibrium that ECB purchases can lead to is one in which the ECB is the only buyer. That is not the desired outcome. The obvious solution is an explicit rate target that the ECB communicated to the market a la the Bagohot Rule since it would require few if any ECB purchases to enforce.
- Sterilisation: The ECB has been particularly keen on trying not to increase the base money supply. So, they have sold other assets in the past whenever they have bought sovereign debt in the SMP. However, Mario Draghi has said that he will ow make no assurances that this will continue to be the case. That means that the new bond purchasing program by the ECB will differ from the old one in two key respects: it will be unlimited in nature with a hidden but explicit yield target and it will not be sterilized. I should note that since reserve quantity is irrelevant for a yield-targeting central bank since loans create reserves, this whole debate is irrelevant as well.
- Political buy in: The most important factor here is who the ECB gets onside before it goes for this policy change. The Bundesbank will never agree to this. So the ECB is explicitly rejecting the Bundesbank’s wishes in favour of a more activist ECB monetary policy. This is significant for those who believed that the ECB would be an extension of the Bundesbank forever. That said, it is clear that Draghi and Asmussen have the German Chancellor’s buy-in and that is important in terms of political concerns which are the real threat to this new policy.
So, there are nine variables which will influence the ECB’s coming monetisation. It is clear this policy change is coming. The question are about timing and specifics, especially given the German constitutional court challenge for the ESM. My view is still that the ECB will operate a hidden target using unlimited liquidity in concert with the ESM in exchange for Troika MoU conditionality from sovereigns. The ECB will likely not go far out the curve. I see three years as a sort of upper bound.
Will this work? I think, yes, it will work if the ECB does provide unlimited liquidity. However, the ECB could end up finding itself as the only buyer given seniority issues and then it has to face the grim prospect that sovereigns fail to meet targets and still need further ECB bond buying one and two years down the line. WHat will the ECB do then. This is the inherent flaw in the currency union. But the ECB has little choice left now. It’s monetisation or bust for the currency union.