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.

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.

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.

Ireland Exits Bailout With No Backstop: A Good News Story?

After years of turmoil, Europe seems to finally have a good news story. Ireland will be the first of country to exit a “troika” program and yesterday its government announced that it would not even be seeking a “precautionary” credit line from Europe’s bailout fund, the ESM.  But is this quite the good news story that most people think it is? I’m not so sure. Indeed, I suspect yesterday’s announcement illustrates how political problems may undermine Mario Draghi’s plans to save the euro.

There is certainly some good economic news coming from Ireland. Targets laid down in the program for the budget deficit were met and while economic growth has been minimal and unemployment is high, employment is now growing again and a large stock of over €20 billion of cash has been built up via borrowings from financial markets and the troika. By the very low bar set by the recent economic performance of the euro area, Ireland is something of a success.

For these reasons, yesterday’s announcement that Ireland would not need a new bailout was not news. This has been known for some time. The news element here was the announcement that there would be no precautionary credit line. But is that actually good news?

Irish government politicians have been keen to claim that there is some good economic news in this announcement, that it “provides clarity” and “reduces uncertainty”.  In fact, the opposite is the case.

A precautionary credit line is something that doesn’t have to be used. Anything that can be done without a precautionary credit line can also be done with one.  However, without such a credit line, the Irish government run the risk of running out of funds and having to negotiate a new bailout or credit line under far less positive circumstances than currently prevail.  This adds to the uncertainties facing Ireland in the coming year, particularly given the possibility that Irish banks may need further recapitalisation next year.

Ireland’s finance minister, Michael Noonan, acknowledged yesterday that economic conditions may not be so benign next year. This should be seen as an argument for negotiating a credit line now but, strangely, Noonan used this observation as an argument for not seeking a credit line.  He seemed to be struggling to find anything better than weak talking points to explain the benefits of not having a credit line.

There is, of course, a narrow political benefit to the Irish government from this “clean” exit, because it allows them to triumph about the full restoration of “sovereignty.”  However, I don’t think they are so cynical as to have made this decision purely for that populist reason.  Instead, my assessment is that the precautionary credit line could not be arranged now because it was politically impossible and that the Irish government are merely putting a brave face on what is a bad outcome.

The political problem is that credit lines from ESM require the approval of all euro area member states and this was not going to be possible now. Germany still does not have a government as Angela Merkel’s CDU continue negotiations with the SPD to form a coalition. During these negotiations, the SPD has regularly insisted that they would not support an ESM credit line for Ireland unless the country followed a series of highly specific policy recommendations.

SPD requirements for approval of a credit line included raising the corporate tax rate and introducing a financial transaction tax. The SPD also ruled out any deal that involved used funds from the credit line to recapitalize banks.

This kind of micro-managing of other people’s economies was not what most people had expected ESM conditionality to look like. Given the existing raft of EU monitoring programs that exist (the six pack, the two pack, the macroeconomic imbalances) a sensible approach would be to require that a country seeking a credit line from ESM commit itself to meeting the recommendations on macroeconomic policy of the European Commission.

When Germany finally has a government and SPD politicians are firmly ensconced in ministerial Mercs, I suspect the desire to micro-manage Ireland’s affairs will recede. However, the damage may well be done. Having sold the Irish public on the idea that the credit line was something to be avoided, it seems unlikely that the government can change its mind next Spring.

This is the odd aspect of yesterday’s decision. Why not announce that Ireland was exiting the program without a precautionary credit line but that discussions about this issue were ongoing? One unattractive possibility is that Ireland’s leaders were asked by their German colleagues to make this announcement to remove it as an issue in the government formation negotiations.

Missed in yesterday’s discussion is that these developments have implications for the ECB’s Outright Monetary Transactions (OMT) program. This is the program announced by Mario Draghi after his “whatever it takes” speech last year.  Under this program, the ECB can purchase unlimited quantities of a country’s government bonds. However, the ECB decided that countries could only avail of OMT if they had an agreement with ESM for a bailout program or precautionary credit line.

Ask yourself this: If star pupil Ireland couldn’t negotiate a precautionary credit line based on reasonable conditionality, what chance is there that a credit line of this sort for Italy will be approved by all countries in the euro area? OMT may have been cast as the plan to save the euro but getting it up and running may not be so easy.

Mr Draghi, The Vicious Circle And The Stress Tests

I was in Brussels on Monday and attended the European Parliament’s Economic and Monetary Affairs Committee for its latest meeting with Mario Draghi. The main topic of the meeting was the ECB’s new job as supervisor of the euro area’s banks. I came away from the meeting very concerned about two issues: The effect of banking problems on sovereign debt and the credibility of the upcoming stress tests.

Mario Draghi, President of the European Centra...

Mario Draghi, President of the European Central Bank. (Image credit: AFP/Getty Images via @daylife)

The Vicious Circle

The decision to allocate the ECB the task of single supervisor for banks stems from the June 2012 meeting of euro area leaders which declared “We affirm that it is imperative to break the vicious circle between banks and sovereigns.”  It was also agreed at that meeting that the euro area’s bailout fund, the European Stabilisation Mechanism (ESM) could be used to recapitalize banks that were in difficulty. For many at the time (including me) this statement was an important positive step.

Because Europe’s leaders would not agree to money being provided to banks in other countries without assurances that these investments had solved problems and could guarantee a return for taxpayers, it became politically imperative that there be a pan-euro-area supervisor of banks that could be relied on to provide an independent assessment.

The ECB has been chosen to do this supervisory job and its first task will be to undertake an assessment next year of the health of the approximately 130 banks that it is to directly supervise. Details on the upcoming assessment process are sketchy at this point other than that it will contain an asset quality review, a balance sheet assessment and stress tests run in conjunction with the European Banking Authority.

MEPs at Monday’s meeting repeatedly questioned Mister Draghi about what would happen if a bank failed the upcoming assessment and needed a large injection of capital. One potential answer was that the proposed new Single Resolution Mechanism, effectively a form of European FDIC, would provide the funds.  However, this mechanism won’t come in to place until 2015 and when it does it won’t have any money: As with the FDIC, it is to be funded over time via contributions to banks.  In the future, the Resolution Fund could borrow from the ESM but it is unclear if this could ever actually happen and highly unlikely that plans will change to see the Resolution Fund swing into action next year.

Instead, Mister Draghi repeatedly emphasized that “national backstops” were the key mechanism for dealing with banks that needed more funds (see reporting here and here.)  This shows how little progress has been made in breaking the vicious circle referred to in last year’s summit statement.

The euro area’s leaders have agreed to a grand plan under which at some point in the fairly distant future, the cost of dealing with bank failures won’t fall directly on the taxpayers unfortunate enough to reside in the same country as the bank. However, for now, Draghi’s comments ensure that national taxpayers remain first in the firing line when banks fail. In this sense, the current vicious circle that actually prompted the June 2012 summit has gone from something that it is “imperative” to remove to something that is effectively official European policy.

Credibility of Stress Tests

The continued reliance on “national backstops” seems likely to affect the credibility of the upcoming stress tests. ECB officials have repeatedly criticised the previous stress tests undertaken by the European Banking Authority for their lack of credibility. Implicit behind this criticism is the assumption that the ECB tests will be tougher, with more negative valuations for bank loans in arrears or other distressed assets.

Draghi’s statements about national backstops, however, undermine the credibility of the new exercise before it has even started. He insisted on Monday that it is realistic for national backstops to be used to sort out banking problems, even in countries like Spain or Greece. Given the perceived size of banking problems in these countries as well as existing levels of public debt, this is effectively an early signal that the new stress tests will not uncover many problems.

The balance sheet assessments will feature many outside advisors who will provide technical expertise in coming up with figures for capital shortfalls. This is a lucrative business and consultants who wish to be re-hired have an incentive to give the answer the client wants. Draghi waxed lyrically on Monday about how

One of the outcomes we expect from these tests is to dispel this fog that lies over bank balance sheets in the euro area

and expressed confidence that the condition of Europe’s banks was improving. This happy message will be taken on board by the outside consultants.

The hiring of Oliver Wyman as the ECB’s own consultant doesn’t do much to boost the credibility of the upcoming assessments. Leaving aside their infamous award to Anglo Irish Bank as the world’s best bank in 2006, this firm carried out stress tests on Spanish banks last year coming up with a €60 billion recapitalisation figure that few consider credible. (For comparison, the Irish state coughed up €64 billion for its banks — Ireland is a lot smaller than Spain and Spanish house prices are still falling.)

Of course, it’s also possible that the bank assessments will be realistically tough and, where public funds cannot be used, the ESM could be called on to provide money for recapitalization. However, the €60 billion currently earmarked for potential use by ESM is a small figure relative to the size of Europe’s bad bank assets and, even then, it seems unlikely that Germany, Finland and the Netherlands will budge from their position that ESM cannot be used to replace losses on “legacy assets.”

A final scenario consistent with the possibility of tough stress tests is that, where national governments don’t have the funds, there will be significant bail-in of bank creditors with bondholders and possibly depositors losing out. Given the chaotic implementation of the Cyprus bail-in and the lack of progress on resolution authority, I seriously doubt that the European institutions have the capacity to execute a simultaneous multi-country programme of bank bail-ins while maintaining financial stability.

That leaves the path of least resistance: Weak stress tests that see the vast majority of banks pass and the problems with bank assets continue to be largely ignored.  With so many new institutions in place, perhaps a gentle run-through was the best that could have been expected from this exercise in any case, with more serious tests reserved for down the road when the banks are in better condition and disagreements about resolution have been settled.

In the meantime, Europe’s weak banks are likely to continue in their zombie state, squeezing credit to firms and households and holding back the recovery that Europe so desperately needs.

Is the Fed Going to Go Bust?

While the Federal Reserve’s quantitative easing program has not yet caused an increase in inflation, many are concerned that the money creation due to QE will provoke serious problems at some point.  So when leading economist Robert E. Hall of Stanford releases a paper (co-authored with Columbia‘s Ricardo Reis) focusing on the “risks to solvency” facing the Fed then many people are going to pay attention.  This is particularly so when the paper includes scenarios in which the Fed loses control of the price level and “the central bank would likely be dissolved and a new currency introduced.”

So is the Fed going to go bust and be dissolved? Will the dollar have to be replaced? Let’s start with a spoiler alert.  In the end, Hall and Reis conclude the possibility of a doomsday scenario for the Fed is “remote”.  Still, given the nature of controversies about the Fed, the extreme scenarios cited in the paper are likely to become part of public debate on the Fed’s future. In this post, I argue that even the “remote possibility” scenarios put forward by Hall and Reis rely on a range of counter-factual assumptions.

A Potential Problem?

Hall and Reis’s concerns can be summarised as follows.  Because the Fed now holds very large amounts of long-dated low-interest-rate bonds, future increases in interest rates may reduce the value of these assets. They describe a scenario in which the Fed reaches a point where its assets don’t generate sufficient income to cover its costs.

In particular, Hall and Reis are concerned about the Fed’s ability to pay interest on the reserve accounts that banks hold with it. Payments made to Fed ultimately arrive via deductions from various reserve accounts that institutions such as private banks or the Treasury hold with it while interest paid on reserves to banks takes the form of additions to the relevant bank reserve accounts.

Given this structure, if the interest payments made to the Fed don’t cover the interest payments it makes on reserves, then the total stock of reserves will increase. Hall and Reis express a concern that this process of additional money creation stemming from such an increase in the stock of reserves would result in higher inflation. (Exactly how this gets so bad that the currency ends up being dissolved is a little unclear to me.)

So it turns out that Hall and Reis are not actually concerned about the Fed going bust in the usual sense of being unable to meet its obligations. Rather they express a concern the Fed might only be able to meet its obligations by creating a quantity of money that generates high inflation.  Alternatively, they discuss a scenario in which the Fed keeps the interest rate on reserves low to restrict the growth in total reserves but this low interest rate results in a loss of control of the price level.

After crunching some numbers, Hall and Reis finally assure worried readers that their scenario in which the Fed loses control of inflation isn’t a likely event.  However, this still leaves some room for doubt that there may be some more extreme set of losses than those contemplated in the paper that could result in a doomsday scenario.

A Problem that Simply Isn’t a Problem

In fact, the doomsday scenario outlined by Hall and Reis simply doesn’t make any sense and it doesn’t require crunching of numbers to dismiss it.

The scenario revolves around the problems caused by payment of interest on reserves.  However, it’s worth noting that, far from being a time-honored tool for controlling interest rates, the Fed only began paying interest on reserves in 2008 and had little difficulty controlling interest rates prior to the introduction of this policy.

As explained in this paper, the principle argument for paying interest on reserves is that it acts as a floor on money market interest rates and so reduces day-to-day volatility.  However, when central banks pay interest on reserves or a deposit facility, this interest rate is rarely the one used to set the target for short-term private sector borrowing rates.

For example, the ECB has a deposit facility that pays interest to banks, an emergency marginal lending facility for overnight borrowing and a weekly refinancing operation in which it lends money to banks. It is the refinancing rate that usually dictates average money market interest rates with the deposit facility rate acting as a lower floor.  So, in general, there are few grounds for the idea that setting a low interest rate for remuneration of reserves (or indeed a zero rate) will lead to the Fed losing control of inflation.

Still, with banks currently flooded with reserves, one could argue that it might be difficult over the next few years to raise the federal funds rate without hiking the interest rate paid on reserves. So one could still ask whether concerns about income shortfalls could lead to the Fed having to abandon paying interest on reserves and the operational efficiency gains that come with it. This is extremely unlikely.

Firstly, the Fed holds large amounts of assets that are set against currency “liabilities” which in practice pay no interest.  So it could incur losses on the rest of its operations and still make a profit. Moreover, there is no operational need for the Fed’s stock of assets to exceed its stock of notional liabilities.

Secondly, the Fed holds long-term assets and short-term liabilities and yield curves generally slope upwards.  So, on average, the Fed is going to make profits even without the assets backing currency notes.  It could thus go through a period of making losses and simply offset these losses with later profits that are partly retained rather than handed over to the US Treasury.

Hall and Reis note in their paper that this latter option of smoothing out profits and losses by varying dividends to the Treasury may not be possible if the Treasury decided to prevent the Fed from accumulating too much profit income without handing it over to the rest of the US government.  Here I can only say that any future world in which the Treasury is allowed to bully the Fed into providing it with more income would indeed be one in which price stability is endangered but only because the Fed will have lost its independence, not because of QE-related losses on assets.

The US economy has many real problems for people to focus on. Economists can help by focusing on those problems rather than fairy stories about the Fed going bust and the dollar being abandoned.