Cantillon on Central Bank Bond Sales

I seem to have annoyed someone with my post about the Central Bank’s bond sales, judging by this discussion of the issue by the Irish Times Cantillon column.

When the promissory notes were swapped for long-term bonds held by the Central Bank last year, various people pointed out that the faster the pace of sales of the bonds to the private sector, the smaller the gains from the swap would be. See for example, my post on this and also Seamus Coffey’s similar conclusions.  I don’t recall anyone disputing this point at the time.

Now, however, Cantillon is here to tell us that this point is “simplistic”.  Apparently, it “ignores the fact that the bank cannot hold the bonds to maturity.”  So who is doing this ignoring? Not Seamus. Not me – our calculations on this have always assumed the Central Bank will sell the bonds.

What then about all this stuff about this being a great time to sell the bonds? You wouldn’t know it from Cantillon’s long-winded discussion but this really is a pretty simple issue.  If we sell the bonds now, we start paying interest straight away and this adds to the cost for the Exchequer.

Of course, it is possible that yields on Irish sovereign bonds may rise so much in the future that we could end up paying more in interest by delaying the bond sales—we extend the period of time that cost is zero but at the expense of much higher interest costs later and this latter factor ends up dominating. With the ECB committed to low interest rates for the foreseeable future, the Irish economy recovering and the debt-GDP ratio falling, this doesn’t seem like a scenario we need to worry too much about.

Cantillon’s final point – that ultimately what’s going in is that faster sales “diffuses at least some of the anger felt in Frankfurt that Ireland in effect obtained monetary financing for itself via the deal” – is of course spot on.  Alas, little is likely to be done to diffuse the anger felt in Ireland about the ECB’s actions during the crisis.

In Ireland, Even Bad News is Good News: Bond Sale Edition

There is lots of good economic news coming out of Ireland these days. GDP is rising at an impressive rate, unemployment is falling, government bond yields are very low and the public finances are improving significantly. In fact, things are so great now that even unmitigatedly bad news is presented as good news.

Thanks to Lorcan Roche Kelly for alerting me to this gem this morning.

So why is the Irish Times article so bad? It reports that the Central Bank is speeding up its sales to the private sector of the bonds it received in place of the promissory notes and that it is now going to sell more than the minimum pace of sales signalled last year. The article clearly signals to readers that this is a piece of good news and does not suggest any downside. The reality is that there is no upside whatsoever to the sales. This is a bad news story all the way.

Why is this? The current arrangement features the Central Bank owning bonds issued by the government.  The government pays interest on these bonds, these interest payments add to the Central Bank’s profits, and then these profits are eventually recycled back to the government. So as long as the Central Bank holds on the bonds, the net cost of this debt to Exchequer is precisely zero.

What happens when the bonds are sold to the private sector? The annual interest payments now go to private sector investors and don’t get recycled back to the government. So the cost is no longer zero.

The replacement of the despised promissory notes in February 2013 with the new bonds acquired by the Central Bank was widely presented as a big improvement for the Irish state. However, economists emphasised at the time that any benefits depended on the pace of sales. See, for instance, the bottom part of this blog post, which illustrates how a faster pace of bond sales can undo most of the perceived benefits of swapping the promissory notes for longer-term bonds.

But surely there must be some goods news here? What of these capital gains the article refers to? This has occurred because Irish government bond yields have fallen since these bonds were issued to the Central Bank. This means they can be sold for lower yields than the par value they had when the Central Bank purchased them, thus implying a profit on disposal.

The private sector investors who buy these bonds will receive the coupon payments set out in the original bond contracts (they pay Euribor plus 263 basis points) but the capital gain made by the Central Bank means that, on net, the interest cost of the sold bonds to the Irish state will equal the new lower yields. Again, the idea that movements in bond yields would influence the ultimate cost of these bonds was flagged in various discussions of the operation last year, include my own post on it.

So the good news here is the Irish government bond yields have fallen and the net cost of selling these bonds is lower than it would have been a few months ago. But selling them at all still means the cost of these bonds goes from zero to positive: From now on, the bonds are going to have an annual cost to the Exchequer, whereas as long as the Central Bank held them there was no net cost at all. A faster pace of sales thus raises costs for the Exchequer.

Like I said, not a good news story.

Monetary Financed-Related Addendum: One point I omitted when I posted this is the following. Some may read this and say: Why can’t the Central Bank just hand back all of the money it receives from the bond sales to the government, not just the capital gain? The answer is that this would violate the agreement the Central Bank has with the ECB via how to unwind the Anglo situation.

The Central Bank loaned over €40 billion to Anglo\IBRC, most of it in the form of Emergency Liquidity Assistance. This involves the creation of new money. The ECB wanted to see the money issued in this fashion retired from circulation when the loans are repaid. IBRC was liquidated without repaying the loans and selling off the new bonds is the current method the Central Bank has agreed with ECB for how this money is to be retired (or “extinguished” as Patrick Honohan puts it).

So if the Central Bank received a bond with a face value of €1 billion, then a sale of that bond to the private sector should result in €1 billion in money being retired. I’m guessing, however, that if the bond is sold for €1.2 billion because yields have fallen, then the Central Bank gets to keep the additional €0.2 billion and still only retires €1 billion.

Alternatively, all of the €1.2 billion goes towards “extinguishment” but this process could mean we still have some bonds left over (which could be retired from the national debt) once the extinguishing is over. Either way, the €200 million capital gain in this hypothetical example reduces the ultimate net cost of the bond sales but does not change the fact that faster sales are bad news.

Draghi on Structural Reforms

I was in Brussels on Monday to present my latest briefing paper to the European Paliament’s Economic and Monetary Affairs committee. The paper addresses issues related to inflation differentials in the euro area and argues that the ECB’s failure to meet its inflation target is significantly complicating the process of adjustment throughout the euro area.

After the briefing, I attended the committee’s “monetary dialogue” session with Mario Draghi. In this session, Draghi repeated a line that he has been using over the past few weeks about how monetary and fiscal policies cannot work unless countries implement a set of unspecified “structural reforms.”  In light of these comments, I’ll repeat the last few paragraphs of my paper here.

As the ECB takes a more active role in battling the ongoing slump, Mario Draghi has intensified his rhetoric about structural reforms. The transcript of his September press conferences shows fifteen uses of this phrase.  Draghi now says he has “concluded that there is no fiscal or monetary stimulus that will produce any effect without ambitious and important, strong, structural reforms.”

It is hard to find a logic (at least one based on macroeconomic theory as we know it) for this argument.  It is certainly the case that potential output growth in the euro area is currently low and can be improved by various policy reforms.  However, it is also true that there is currently a very large shortfall between aggregate demand and the current supply potential of the euro area economy, a shortfall summarised in an unemployment rate of over 11 percent.  So there is room for fiscal and monetary stimulus to boost the economy, even without structural reforms.  In addition, to the extent that we are worried about deflation, the initial impact of structural reforms that boosted the supply capacity of the euro area would be to further depress inflation.

My point here is not to argue against structural reforms. There are many such reforms that can have an important positive effect over the medium- and longer-run (though we know little about the magnitude of their potential impact). But it is important for the ECB to take responsibility for its crucial role in the shorter-term macroeconomic management of the euro area and ECB officials continually placing structural reforms at the heart of discussions of this issue is unhelpful.

Draghi has many very well-qualified economic advisers — one of the very best, Frank Smets, was sitting beside him at the monetary dialogue. Let’s hope they can pursuade him to abandon this unfortunate and unnecessary line of rhetoric.

MA Macroeconomics

This is the class website for University College Dublin module MA Macroeconomics (ECON 41990) in  Autumn 2014.

Information and Assessment

A syllabus for the course (including details of the assessment) is available here.  The School of Economic gradescale is here.

Here is a handout with guidelines on the final exam and sample questions for the first section of the exam.  (Final edition).

Here are sample questions for the second part of the final exam as well as some guidelines for answering the questions. (Final edition).

 Lecture Notes

1. The IS-LM Model. (From MIT Open Courseware)

2. The AS-AD Model. (From MIT Open Courseware)

My summary of IS-LM and AS-AD

Click on the name of the topics below to obtain the lecture notes. Note these are longer and more detailed than the slides.

3. Introducing the IS-MP-PC Model. Slides here.

4. Analysing the IS-MP-PC Model. Slides here.

5. The Taylor Principle. Slides here.

6. The Zero Lower Bound and the Liquidity TrapSlides here.

7. Rational Expectations and Asset Prices. Slides here.

8. Rational Expectations, Consumption and Asset Pricing. Slides here.

9. Sticky Prices and the Phillips Curve. Slides here.

10. Growth Accounting. Slides here.

11. The Solow Model. Slides here.

12. Endogenous Technological Change: The Romer Model.  Slides here.

13. Cross-Country Technology Diffusion.  Slides here.

14. Institutions and Efficiency.  Slides here.


John Hicks (1937). Mr. Keynes and the Classics: A Suggested Interpretation

Mark Bils and Peter Klenow (2004). Some Evidence on the Importance of Sticky Prices

Alvarez et al (2005). Sticky Prices in the Euro Area

Carl Walsh (2002): Teaching Inflation Targeting: An Analysis for Intermediate Macro

Milton Friedman (1968): The Role of Monetary Policy.

John Taylor (1993): Discretion Versus Policy Rules in Practice

Bank of England (2012): State of the Art of Inflation Targeting

Richard Clarida, Jordi Gali and Mark Gertler (2000): Monetary Policy Rules
and Macroeconomic Stability: Evidence and Some Theory

Athanasios Orphanides (2001). Monetary Policy Rules, Macroeconomic Stability and Inflation: A View from the Trenches

Ben Bernanke (2003):  Some Thoughts on Monetary Policy in Japan

Lars Svensson (2003). Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others

Paul Krugman (2012): Earth to Ben Bernanke. Chairman Bernanke Should Listen to Professor Bernanke

Eugene Fama (1970): Efficient Capital Markets: A Review of Theory and Empirical Work

Eugene Fama (1991): Efficient Capital Markets II

Robert Shiller (1981): Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?

John Campbell and Robert Shiller (2001). Valuation Ratios and the Long-Run Stock Market Outlook: An Update.

Gavyn Davies: The Nobel  Laureates on Equity Bubbles

NBER Workshop on Behavioural Finance.

Robert Lucas (1976). Econometric Policy Evaluation: A Critique.

Robert Hall (1978). Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence.

John Campbell and Gregory Mankiw (1990). Permanent Income, Current Income, and Consumption

Robert Barro (1974). Are Government Bonds Net Wealth?

Jonathan Parker, Nicholas Souleles, David Johnson and Robert McClelland (2011). Consumer Spending and the Economic Stimulus Payments of 2008.

Jonathan Parker (1999). The Reaction of Household Consumption to Predictable Changes in Social Security Taxes.

Chang-Tai Hsieh (2003). Do Consumers React to Anticipated Income Changes? Evidence from the Alaska Permanent Fund

Bureau of Labor Statistics MFP Trends up to 2013

Karl Whelan: Is the U.S. Set for an Era of Slow Growth?

Kieran McQuinn and Karl Whelan (2014): Presentation on Demographics, Structural Reform and the Growth Outlook for Europe.

Alwyn Young (1992): A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore

Edward Miguel and Gerard Roland (2009): The Long Run Impact of Bombing Vietnam

Paul Krugman (1994): The Myth of Asia’s Miracle

Paul Romer (1990) : Endogenous Technological Change.

Robert Gordon (2012): Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds

Robert Gordon (2014): The Demise of U.S. Growth: Restatement, Rebuttal and Reflections

Joel Mokyr (2013): Is Technological Progress a Thing of the Past?

Robert E. Hall and Charles I. Jones (1999). Why Do Some Countries Produce So Much More Output per Worker than Others?

Douglass North (1999). Institutional Change: A Framework of Analysis.

Daron Acemoglu, Simon Johnson and James Robinson (2001). The Colonial Origins of Comparative Development: An Empirical Investigation.

Dani Rodrik, Arvind Subramanian, and Francesco Trebbi (2002). Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development.

Robert Gillanders and Karl Whelan (2014). Open For Business? Institutions, Business Environment and Economic Development.