Here‘s a link to my speaking notes for a talk that I gave tonight at the McGill Summer School. The session’s thought-provoking title was “With Huge Debt and Resulting Austerity, Is Serious Economic Growth Possible?”
Ok, the headline might be a bit over the top but I felt compelled to write this post after having so many conversations with people who follow Europe but had never heard of the deadly Risk Control Framework.
The byzantine complexities of the IBRC’s promissory note-emergency liquidity assistance arrangements are such that it is inevitable that even the smartest of people will get confused. Unfortunately, Irish Times reporter Arthur Beesley (who does excellent work covering Brussels) came a cropper in this morning’s article on the negotations over restructuring Ireland’s bank-related debt.
Arthur’s article discusses the issues as follows:
On the table is the provision of about €30 billion in bonds from a European bailout fund to the former Anglo Irish Bank to replace expensive State-funded promissory notes …
The release of European bonds to the former Anglo would be in addition to the €40.2 billion Ireland is receiving from European sources under the original bailout agreement.
This is one element of the package which would certainly necessitate parliamentary votes in a number of countries.
The key issue in this part of the negotiation is the rate of interest which would be charged on any bonds from the temporary European Financial Stability Facility or its successor, the ESM.
The basic idea is that the Government would remain on the hook for EFSF or ESM bonds given to the former Anglo but that the annual interest rate charged would be far lower than the 8.2 per cent which applies now.
Precisely what rate would be charged remains subject to negotiation, the official said.
Under present arrangements the State would pay €16.8 billion in interest by 2031, bringing the total cost of the Anglo note scheme to €47.4 billion.
This description misses the key issues at stake here in a number of ways.
The problem with the promissory note arrangement is not that it causes the state to incur high interest costs. In fact, the opposite is the case. The 8.2 percent interest rate quoted here relates to interest payments that the state is making to IBRC, a state-owned institution. This is one arm of the state paying another so the interest rate has no impact on the state’s underlying debt situation.
In the same way, the IBRC uses its promissory note payments to repay its ELA debts to the Central Bank of Ireland (another arm of the state) and the (lower) interest rate it pays on ELA also has no relevance. The Central Bank returns the profits it makes on these ELA loans to the state (see its 2011 annual report).
What is the interest cost to the state of the current arrangement? As I described in detail in this paper, the Central Bank takes in the principal payments on ELA and then retires the money that it created when granting the ELA in the first place. This reduces the balance sheet item “Intra-Eurosystem Liabilities” which the Bank currently pays 0.75% percent on.
So the effective interest rate to the state of the promissory note arrangement is 0.75%, not 8.2%. The problem with the current arrangement is not the interest rate but rather the schedule for repayment of the principal, which will see a punishing 2 percent of GDP paid over each year over the next ten years.
The article mentions a figure for the total cost of the promissory notes of €47.4 billion. However, because most of the interest cost is returned to the state, the true net cost is far lower. Effectively, the total cost will be the €31 billion in principal on the notes that were issued plus the cumulated interest costs calculated at the ECB refinancing rate. This will be far less than €47.4 billion.
In relation to substance, the article suggests the negotiations are focused on replacing the promissory notes with bonds from the EFSF and or ESM, which could then be repo’d with the ECB allowing most of the ELA borrowings to be paid off. The state would then provide EFSF\ESM with the funds to cover the annual interest on the bonds with funds.
One version of this arrangement could see the bonds pay out €30 billion in 2042, with the Irish state providing the principal to EFSF\ESM and IBRC finally repaying the ECB. A more likely scenario would see a gradual repayment of the principal via repayment of ECB and retirement of the EFSF bonds.
If these bonds are placed directly rather than borrowed from the market, then one could argue that they should carry an interest rate of close to zero, since the EFSF is no longer adding a profit margin to its cost of funds (and the cost in this case is zero).
An arrangement of this type could mimic the low interest cost to the state of the current arrangements while adding a long-term schedule for repayment of principal. However, it carries with it some serious political complications. As the Times article notes, this arrangement would require political approval throughout Europe and that may be difficult obtain. In addition, this debt would have to be repaid even if Ireland left the euro because of its official status, while a post-euro Central Bank of Ireland would have the option of agreeing to a unilateral restructuring of the promissory notes.
An alternative arrangement that avoids these political risks is to simply alter the current arrangements to have the promissory note schedule be far more back-loaded than at present. This requires only the agreement of the ECB. As I wrote here a few weeks ago, there is a strong argument that it is time the ECB could Ireland some slack.
This is the class website for University College Dublin module ECON 30150, taught by Prof. Karl Whelan. The module focuses on central banks, monetary policy and the role of the banking system in the economy.
Here is a handout describing the structure of the module, assessment and other details.
Your final grade will be based on 20% for a multiple-choice mid-term exam and 80% for a final exam. Your final grade is calculated by grade point averaging, i.e. your final grade will be decided by a weighted average of the calculation point for your midterm and the calculation point for your final exam.
Here is the final list of sample questions for the final exam.
11. Default Risk
13. Asset Prices
15. The Taylor Rule
17. The Euro Crisis
Readings and Useful Links
Bank of Ireland’s 2011 Annual Report.
Cleveland Fed: Bank Capital Requirements: A Conversation with the Experts
Patrick Honohan’s Report: The Irish Banking Crisis Regulatory and Financial Stability Policy 2003-2008.
Charles Goodhart: Two Concepts of Money
The weekly consolidated balance sheet of the Eurosystem from the ECB.
Karl Whelan: Is the ECB Risking Insolvency? Does it Matter?
Karl Whelan: No, the Bundesbank has not reached its limit
Karl Whelan: Target2 and the Euro Crisis
Guy Debelle: On Europe’s Effects on Australian Financial Markets
Todd Keister and James McAndrews Why Are Banks Holding So Many Excess Reserves?
Paul De Grauwe and Magdalena Polan: Is Inflation Always and Everywhere a Monetary Phenomenon?
Steve H. Hanke and Nicholas Krus: World Hyperinflations
ECB Protocol (i.e. the legal statute underlying the ECB and Eurosystem).
Karl Whelan: The Secret Tool Draghi Uses to Run Europe
Ben Bernanke: Implementing Monetary Policy
Ben Bernanke: Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression (American Economic Review, June 1983. Not available outside UCD. Go through UCD Connect and the Library Page.)
FDIC Failed Bank List.
Karl Whelan: Containing Systemic Risk (Paper submitted to European Parliament.)
Ben Bernanke: Implications of the Financial Crisis for Economics
Piergiorgio Alessandri and Andrew Haldane (Bank of England): Banking on the State
Simon Johnson: Economic Recovery And The Coming Financial Crisis.
Douglas Diamond and Raghuram Rajan: The Credit Crisis: Conjectures about Causes and Remedies
Documentation for the Basle 2 Internal Ratings Based model.
Philipp Hildebrand: Is Basel II Enough? The Benefits of a Leverage Ratio
New York Times: Risk Mismangement
Patrick Honohan: Bank Failures: The Limits of Risk Modelling
Andrew Haldane and Vasileios Madouros. The Dog and the Frisbee.
Samuel Hanson, Anil Kashyap and Jeremy Stein: A Macroprudential Approach to Financial Regulation
Basle 3 Agreement
Andrew Haldane: The Bank and the banks.
Selected Interest Rates from the Federal Reserve.
Bloomberg Yield Curve Page
Ben Bernanke: The Financial Accelerator and the Credit Channel
Joseph Gagnon, Matthew Raskin, Julie Remache, Brian Sack: Large-Scale Asset Purchases by the Federal Reserve: Did They Work?
Stefania D’Amico and Thomas B. King: Flow and Stock Effects of Large-Scale Treasury Purchases
Donald Kohn: Monetary Policy and Asset Prices
Milton Friedman: The Role of Monetary Policy.
Ben Bernanke: The Benefits of Price Stability
Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro: Rethinking Macroeconomic Policy
John Taylor: Discretion Versus Policy Rules in Practice
Glenn Rudebusch: The Fed’s Monetary Policy Response to the Current Crisis
Karl Whelan: Macroeconomic Imbalances in the Euro Area
Karl Whelan: Would a Greek Exit Really be Manageable?
ECB Legal Paper: Withdrawal and Expulsion from the EU and EMU: Some Reflections
Barry Eichengreen: The Breakup of the Euro Area (May 2007)
The Wall Street Journal is reporting that the ECB has changed its position on the need to protect all senior bond holders at European banks. My current thoughts here. I will write more later about the implications of this development for Ireland.
With the release of a draft Memorandum of Understanding for Spain, it appears that the EU may be preparing to protect senior bondholders of insolvent banks in Spain, just as they did in Ireland. My thoughts here.
Last night’s Euro group meeting failed to resolve any of the uncertainty about the ultimate liability for ESM bank recaps and provided a commitment to do nothing about it until September. My thoughts here.
After some reasons to be optimistic that Europe’s leaders were ready to finally grasp the bank debt\sovereign debt nettle, the developments of the last few days have been exasperating to watch. My latest thoughts here.
I have written a new briefing paper for the European Parliament’s Economic and Monetary Affairs committee. The paper discusses the ECB’s role in Ireland’s financial assistance programme. Here’s the abstract:
This paper reviews the role the ECB has played in financial assistances programmes in the Euro area, focusing in particular on Ireland. The ECB’s involvement in Ireland—in particular its policy in relation to senior bank debt—has raised questions about whether it has over-stretched to act beyond its mandate. The ECB is not providing official assistance to the Irish government and its involvement in monitoring the programme has confused the public about the nature of the programme’s conditionality and contributed to undermining its legitimacy. I recommend that future financial assistance programmes should not feature the ECB as a member of a Troika tasked with monitoring the programme. The ECB’s relationships with other crisis countries are reviewed. I conclude that Europe needs to clarify its policies on bank resolution and systemic risk—and the role of the ECB in relation to these policies—before it is too late.
The other briefing papers (some more on the ECB’s role in financial adjustment programmes and others on the response of central banks around the world to the crisis) can be found here. Click on 09.07.2012.