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 is available here.

Here is a handout with guidelines on the assessment for the module.  (Updated: September 29).

Here are sample questions for the midterm exam. (Updated: September 29).

The midterm will take place on Wednesday October 22 between 2.30 and 3.30 in Newman Theatre 1, which is in the basement of the building.

 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

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.

 

Readings

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.

The ECB and Non-Standard Policies: Too Little Too Late?

The latest round of briefing papers for the Economic and Monetary Affairs committee’s monetary dialogue can be found here. Click on 14.07.2014.  The papers discuss the strength of the euro and non-standard monetary policies. My paper is “The ECB and Non-Standard Policies: Too Little Too Late?”  Click here for a version without the nasty “Draft” watermark. The paper contrasts the ECB’s approach to monetary policy in recent years with the that of the Federal Reserve. It also discusses the actions taken at the June Governing Council meeting and addresses issues relating to potential future asset purchase programmes. The abstract for the paper is as follows:

The ECB has been slower to cut interest rates and to consider asset purchase programmes than the other major central banks even though the euro area economy has performed worse than its comparators. This failure to act has not stemmed directly from the ECB’s price stability mandate. Indeed, by not acting sufficiently strongly, the ECB is now failing to meet its own definition of price stability. The measures introduced at the ECB’s June Governing Council meeting will have only a modest positive effect on the euro area economy. Large asset purchase programmes – of both sovereign bonds and private asset-backed securities – are overdue.

Options for Ireland’s Legacy Bank Debt

Prior to the recent European elections, I was commissioned by the Labour Party to write a briefing document outlining the nature of Ireland’s “legacy” bank debt and to discuss the potential options for reducing the burden associated with this debt.  The document has now been publicly released by the Labour Party and is available here.

With the two-year anniversary of the 2012 Eurosummit coming up in a few weeks, it is a good time to re-examine the commitments made by Euro area heads of state on this issue and for Ireland’s government to make the case for action.

Europe’s Bank Assessment: A Worrying Preview From Ireland

The most important thing happening in the European economy over the next year is the ECB’s comprehensive assessment of large euro area banks.  This process will involve an asset quality review, a supervisory risk assessment and a stress test followed by the requirement that banks be recapitalised to address weaknesses that are found.  Yesterday, we got a preview from Ireland as to how this process might work and it wasn’t at all pretty. In fact, it was pretty shambolic.

English: Central Bank of Ireland located on Da...

Central Bank of Ireland located on Dame Street in Dublin. (Photo credit: Wikipedia)

Because Ireland’s banking sector played a major role in sending the country into an EU-IMF program, the troika decided that Ireland’s bank assessment should begin prior to the other countries. So yesterday, the three Irish banks involved in the European bank assessment announced that they had received the results of a “balance sheet assessment” of their accounts of June 2013 from the Central Bank of Ireland (the terminology in relation to the comprehensive assessment changed over the course of the year but this balance sheet assessment appears to be what the ECB now calls an “asset quality review”.)

The timing of these announcements now looks a bit awkward. Originally, the idea seemed to be to have the announcements take place just prior to the ECB’s process for other countries but the timeline on the ECB’s assessment has slipped. It will now review bank balance sheets as of December 31, 2013, so interpreted strictly the Irish banks will need another balance sheet assessment again early next year.  This begs the question why the Central Bank of Ireland (and ECB, who must have been involved) bothered to release the assessment of the June 2013 books at all.

If the timing of the balance sheet assessment was bad, the handling of the announcements was far worse.  As of yet, the Central Bank of Irelandhas made no statement whatsoever on the balance sheet assessments. (Here is its list of press releases.)  Instead, the three banks involved all released their own statements with varying amounts of information disclosed.

Revealing the most information was Bank of Ireland.  This bank released a sheet of information (“Schedule 1”) that looked like something provided to it by the Central Bank of Ireland.  The sheet showed that the Central Bank believed capital was lower and risk-weighted assets higher than the bank’s own accounts showed.

Calculated according to the 2014 regulatory capital rules, the Central Bank believes Bank of Ireland had a common equity tier 1 capital ratio of 9.85% in June while the bank’s own accounting treatment showed a figure of 13.8%.  This 9.8% is still above the 8% ratio that will be required by the ECB following next year’s exercise.  However, it would be below the 10.5% requirement that the Central Bank of Ireland has itself set in recent years.  By this year’s regulatory capital rules, the Central Bank views Bank of Ireland’s common equity tier 1 ratio as 10.6% which is just above this requirement.

Does this mean that Bank of Ireland’s capital ratio is about to be written down by four percentage points? The Central Bank is its regulator so you might imagine that this would be the case.  However, Bank of Ireland’s statement contains a number of criticisms of the Central Bank’s calculations.  Indeed, the bank “remains confident in its own methodologies, calculations and impairment provisions” and the statement merely says the results will “remain subject to ongoing engagement” with the Central Bank.

The Central Bank certainly has the powers to compel Bank of Ireland to raise capital on the basis of its own assessment and this may be what happens.  But it is not clear to me whether Bank of Ireland will be forced to release year-end accounts calculated in line with the methodologies preferred by the Central Bank of Ireland.

All told, it’s hard to know what Bank of Ireland’s reported capital ratios will be in its next report. However, the fact that a stress test has to be done next year and that this exercise will involve further (yet to be determined) capital requirements suggests that the bank will probably need to raise more capital.

If things are a little unclear with respect to Bank of Ireland, the situation is clear as mud when it comes to the other two banks that made announcements yesterday.

Allied Irish Banks (AIB) put out a terse announcement unaccompanied by a Schedule 1 sheet.  It stated

AIB has been advised of the findings of this review which it will consider in the preparation of the bank’s year end December 2013 provisions and financial statements.

Based on an initial assessment of the findings of the BSA, the Bank believes it continues to be well capitalised and in excess of minimum regulatory requirements.

You might be tempted to read that statement and conclude that AIB’s “Schedule 1” sheet showed that it was well-capitalised and did not need to raise new capital. I think that’s a bit optimistic.  AsBill Clinton might say, it depends on what the meaning of “Bank” is.

Given that the “Bank” in question had to do “an initial assessment of the findings” to come up with the “belief” that it is well capitalised, then my interpretation is that the “Bank that believes” is AIB. (The capital B being an affectation the bank (all lower case) likes to use in press releases.)

So the bank (or Bank …) believes that it’s well-capitalised. Well good for them. But remember that Bank of Ireland also disagreed with the Central Bank and believe their own figures are better.  So there’s a lot of subjective beliefs floating around here. Most likely, AIB’s Schedule 1 sheet shows that it requires more capital.

Then there’s the most tight-lipped of the three banks, Permanent TSB, who provided no figures and simply stated

Based on the communicated results the outcome confirms that the capital position of permanent tsb plc is above minimum regulatory requirements.

What this means depends upon whose notion of “minimum regulatory requirements” you’re thinking of.  It could mean above the Central Bank of Ireland’s guidelines of 10.5% or it could mean above the current European CRD4 minimum common equity ratio of 3.5%.  A cynic might suggest that if it was the former then the bank would have released the results. Perhaps modest PTSB (who describe themselves without using a single upper-case letter) are hiding a set of fantastic results. Perhaps not.

The Central Bank of Ireland and the ECB should remember that the purpose of this exercise is to bring clarity to bank balance sheets. Yesterday’s events achieved the exact opposite with people scratching their heads interpreting strangely-worded statements and wondering about the figures that were not reported.

The ECB needs to use yesterday’s events as a lesson. It would not be acceptable for this kind of shambles to be repeated whenever the first stage of the ECB’s comprehensive assessment is completed. Either all banks involved in the process reveal the details of their assessment or else the whole exercise should be conducted in secret.  Allowing stronger banks to report results while we are left wondering about the weaker ones is a recipe for financial instability.

So What’s So Special About Bitcoin?

I received a number of thoughtful comments on yesterday’s article on Bitcoin and wanted to follow up on a couple of important points that they raised and provide some new information.

Some of the pro-Bitcoin enthusiasts were keen to emphasize the difference between Bitcoin and previous potential sources of private money.  It’s digital, so doesn’t have physical production or storage issues and it’s hard to melt down a Bitcoin and pass it off as two Bitcoins, thus perhaps ruling out the role governments played in verifying and securing money in the past.

However, commenters were also keen to emphasize that Bitcoin is special because it can only be created according to a special algorithm that ultimately limits the total number of Bitcoins to 21 million and guarantees that payments are anonymous and irreversible.

The fact that Bitcoin advocates rely so heavily on the niftiness of its underlying algorithms and protocol is one of the best reasons to predict its demise.  If all you have going for you is a cool algorithm, then at some point there will be someone else out there with an even cooler algorithm. And then someone else.

Indeed, there is evidence that this process is already underway. If you don’t want to use Bitcoin, you can always try Litecoin. It promises to be

a peer-to-peer Internet currency that enables instant payments to anyone in the world. It is based on the Bitcoin protocol but differs from Bitcoin in that it can be efficiently mined with consumer-grade hardware. Litecoin provides faster transaction confirmations (2.5 minutes on average) and uses a memory-hard, scrypt-based mining proof-of-work algorithm to target the regular computers and GPUs most people already have. The Litecoin network is scheduled to produce 84 million currency units.

And if you’re in it for the speculation, Litecoin is showing some nice bubbly movements as well.

Or maybe you could go with Primecoin, an

experimental cryptocurrency that introduces the first scientific computing proof-of-work to cryptocurrency technology. Primecoin’s proof-of-work is an innovative design based on searching for prime number chains, providing potential scientific value in addition to minting and security for the network.

Supporting private money and adding scientific value, what’s not to like?

Perhaps though, you are kept awake at night worrying about a 51% attack (no it doesn’t involve aliens or Area 51). In that case, perhaps Peercoin is for you

Peercoin’s major difference from Bitcoin is that it uses a proof-of-stake/proof-of-work hybrid system for coin generation. With this system, coins are generated based on proof-of-stake blocks in addition to proof-of-work blocks. In other words, someone holding 1% of the currency will generate 1% of all proof-of-stake coin blocks.

Proof-of-stake block generation could reduce the risk of 51% attacks ….

This little tour of crypto-currencies (and there’s plenty more) should be enough to convince you that one of these outfits will probably produce a currency that is widely seen as superior to Bitcoin along most dimensions, perhaps attracting lots of supporters on websites and Russian-government-sponsored TV shows.

What happens then to your Bitcoins then?  Even Bitcoin’s own FAQ is clear about the uncertainties surrounding its future.  A brief excerpt:

Can bitcoins become worthless?

Yes. History is littered with currencies that failed and are no longer used, such as the German Mark during the Weimar Republic and, more recently, the Zimbabwean dollar. Although previous currency failures were typically due to hyperinflation of a kind that Bitcoin makes impossible, there is always potential for technical failures, competing currencies, political issues and so on.

So even if private crypto-currencies are the future, that doesn’t mean that Bitcoins will feature in that future. It’s a bit like investing all your money in IBM in the 1970s because you’re sure computers are the next big thing even though you haven’t yet heard of Microsoft or Apple. Or taking a punt on Pets.com in 1999 because the Internet is the future and sure people will still have pets in the future.

The difference in this case is that private currencies are probably not the future.  The very fact that no single private currency can be relied on to have the necessary unique features to become a useful source of value is likely to undermine the whole idea. Like it or not, the US federal government is going to be with us for the foreseeable future, printing dollars, requiring tax payments in those same dollars and enforcing the requirement that creditors must accept dollars as legal tender. Dollars are not going to be dislodged by Bitcoin, Primecoin, Karlcoin or whatever.

Of course, commenters did note another advantage of Bitcoins. They may possibly help to facilitate illegal activities and tax evasion. If that’s why you’re buying Bitcoins, all I can say is good luck with that. Uncle Sam is watching you.