Category Archives: Euro Crisis

Would A Greek Exit Really Be Manageable?

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Jean-Claude Juncker, Luxembourg prime minster and head of the Eurogroup of finance ministers has said that he believes that a Greek exit from the euro would be “manageable”  Partially based on my recent experience of Ireland’s banking crisis, which was “manageable” until suddenly it wasn’t, I don’t take much reassurance from politicians using this phrase.

In many ways, this was a fairly typical intervention from Juncker, who has a touch of foot-in-mouth disease.  His comments appear to have begun as a dismissal of German politicians saying they are not worried about Greek exit with Juncker pointing out “it would be better if more people in Europe kept their mouth closed more often”.  Indeed. But then this particular piece of reassurance comes from the man who, when caught lying last year about an emergency finance ministers meeting on Greece, responded “When it becomes serious, you have to lie.”

So what’s the case for a Greek exit being manageable? One could argue that the euro existed for a time without Greece and functioned fine, that allowing Greece to join was a mistake, and thus that a euro without Greece would be more stable.  While some of the countries that would remain in the euro also have severe debt problems, you could argue that they were not as intractable as Greece’s.

Finally, you could argue that the Eurosystem would provide full support to the governments and banks in the remaining countries provided, of course, that they don’t go the Greek route and fail to control their debt problems.  In other words, some believe a Greek exit could reinforce the rules required to maintain the stability of the euro by showing that the core countries are serious about their enforcement.

I think these arguments under-estimate the seismic impact a Greek exit would have and I have severe doubts as to whether these impacts could be managed in a way that saves the euro.

A Greek exit would forever shatter the illusion that the euro is a fixed and irrevocable union. European politicians will claim that Greece is a unique case but they have made far too many false claims in the past to be considered credible.

A Greek exit would likely trigger a massive flight of bank deposits from the periphery as the current “bank jog”—largely driven by large corporate accounts and non-residents—turns into a full retail bank run.  If default on deposits is to be avoided, this would require a massive injection of central bank funding by the Eurosystem into these countries.  This would raise severe tensions: Will Germans be willing to allow the Banca d’Italia to print enormous amounts of euros to facilitate Italians to move their money to Germany and have their deposits stand on an equal footing with German resident deposits after a euro break-up?

Another possible response to a bank run would be the introduction of euro-wide deposit insurance. However, this plan would only work provided it guaranteed that people retained the original value of their euro deposits even after they had been re-donominated into pesetas or lira.  Otherwise, people will still have an incentive to move their money.  But re-denomination insurance provides a huge incentive for countries to leave.  People can have their debts re-denominated into a weaker currency and the EU will kindly pick up the tab in relation to the money people lose on their deposits.  This proposal would not be acceptable to the core Eurozone countries.

A Greek exit would trigger a broad range of different legal problems as various parties sue each other to claim they are owed euros, not drachmas.  The resolution of these problems would illustrate which kinds of parties are at risk when a country exits the euro and their Spanish and Italian counterparts would come under severe pressure.

A Greek exit would place pressure under peripheral Eurozone economies no matter what the outcome is.  A disastrous post-euro outcome in Greece will convince many investors that any economy in the euro area at risk of leaving should be avoided.  Alternatively, a healthy Greek rebound after the initial chaos would place pressure on governments in countries suffering inside the Eurozone that Greece is an example to be followed.

The European authorities may have some secret plan for holding the euro together after a Greek exit but, frankly, I have my doubts.

Is the ECB Risking Insolvency? Does it Matter?

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After Mario Draghi’s hints that the ECB is getting ready to purchase large quantities of Spanish and Italian bonds, expect to read lots of commentary claiming “the ECB is taking huge risks with its balance sheet”, that “the ECB risks becoming insolvent, endangering the future of the euro” or that “Eurozone states may have to recapitalize the ECB at huge cost to taxpayers”.

Much of this commentary is based on misunderstanding the facts about the Eurosystem’s balance sheet and the meaning of central bank balance sheets.  In this post, I want to briefly explain what a central bank balance sheet is, then go through the basic facts about the capital position of the Eurosystem of central banks and then argue that the common focus on central bank solvency is misplaced.

Central Bank Balance Sheets

Like all businesses, central banks publish balance sheets that show their assets and liabilities. However, central banks are not just any business. They have the power to print money that is accepted as legal tender.  So their assets have been acquired via printing of money.  Central banks list the money they have created as liabilities and the gap between the current value of their assets and liabilities is labelled “capital”.

So a stylized central bank balance sheet looks as follows.

CB-BalanceSheet3

 

If a central bank purchases assets that then decline in value, it could end up having negative capital.  When a commercial bank has negative capital, it is termed insolvent and either re-capitalised or shut down.  The “insolvent” terminology is sometimes applied to a central bank in this situation but, as I discuss below, central banks are unique organizations and this phrase isn’t particularly appropriate.

Bond-Buying Risk: Eurosystem not ECB

A common confusion that arises when people discuss potential losses stemming from sovereign bond purchases or loans to banks comes from the assumption that the risk of these operations lies with the European Central Bank.  For example, it is common to see commentary that examines the ECB’s balance sheet and concludes that the ECB faces a significant risk of becoming insolvent. This is because the ECB lists “Capital and Reserves” of only €6.5 billion, a tiny amount relative to the likely scale of bond purchases likely to be executed under the Securities Market Programme (SMP).

In fact, the ECB also has revaluation accounts and provisions, both of which can cover losses, worth €30 billion. More importantly, the risks associated with the bond-buying program are in fact shared across the ECB and all of the national central banks in the Eurosystem. So what matters when thinking about the threat to solvency of the SMP is the size of the Eurosystem’s capital resources.

The ECB releases a Eurosystem financial statement every week. Currently, it shows capital and reserves of €86 billion and revaluation reserves of €409 billion.   These figures show the Eurosystem would have to incur much larger losses on its bond purchases than is often believed before the question of insolvency would become an issue.

Would Eurosystem Insolvency Matter?

This still raises an interesting question. What would happen if the ECB published its weekly balance sheet one day and it showed negative capital? For many commentators, the answer is apocalyptic. The euro will have lost all credibility as currency, hyper-inflation will ensue, that kind of thing.

In truth, the answer is that not much at all would happen. The euro is a fiat currency. In other words, unlike the days of the gold standard, the Eurosystem does not promise to swap the euro at some specified rate for another asset such as gold. The currency is not “backed” by the central bank’s assets.

Since central bank money costs next to nothing to create, the “Liabilities” on its balance sheet are essentially notional. Indeed, a central bank’s asset holdings could fall below the value of the money it has issued – the balance sheet could show it to be “insolvent” – without impacting on the value of the currency in circulation. A fiat currency’s value, its real purchasing power, is determined by how much money has been supplied and the various factors influencing money demand, not by the stock of central bank assets.

Taken to an extreme, one could argue that a central bank with sufficiently negative capital could face problems implementing monetary policy because its stock of assets may be so low as to limit its ability to sell assets to reduce the supply of privately circulating money. However, detailed analytical research by ECB economists Ulrich Bindseil, Andres Manzanares and Benedict Weller concludes that

central bank capital still does not seem to matter for monetary policy implementation, in essence because negative levels of capital do not represent any threat to the central bank being able to pay for whatever costs it has. Although losses may easily accumulate over a long period of time and lead to a huge negative capital, no reason emerges why this could affect the central bank’s ability to control interest rates.

Despite the absence of reasons to be concerned about negative central bank capital, it is still unlikely that such an outcome would be allowed to continue in the Eurozone.  The actual rules relating to central bank solvency seem a bit murky but it is generally understood that any element of the Eurosystem that had negative capital would need to be recapitalized by governments providing them with assets.

Even then, these “recapitalizing” transactions wouldn’t actually have any effect on the net asset position of Eurozone governments because central banks hand over their profits to the government. For example, suppose a government hands its central bank a bond that pays €500 million in interest each year. That raises the net income of the central bank by €500 million and thus raises the amount that is handed back to the government by €500 million.  The bond has no net cost to the government.

By these comments, I’m not suggesting that bond purchase programs have no cost. To the extent that they involve increasing the money supply, they can contribute to inflation so there is an implicit cost for all citizens. But this is the reason central banks need to be careful with their purchases; concerns about central bank solvency are beside the point.

Unfortunately, despite its lack of substantive importance, the idea that the Eurosystem needs to be protected from balance sheet insolvency has featured heavily in discussions of policy options. Indeed, it is well known that senior ECB officials are extremely concerned with protecting their balance sheet and have employed their “risk control framework” to protect themselves from losses at many of the key moments in the euro crisis.

One can only hope that the policy debate about the upcoming bond purchases focuses on things that matter, like the future of the euro, and not on things that don’t, like the ECB’s capital levels.

The Secret Tool Draghi Uses to Run Europe

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Everyone knows central banks are powerful. When I used to visit Alan Greenspan’s office back when I worked for the Fed, he had a sign that said “The buck starts here.” As powerful tools go, there’s nothing that quite beats the power to print money.

So it goes without saying that ECB President Mario Draghi is powerful.  He decides how much money is printed in Europe and what the cost of borrowing that money will be.  But dig deeper and you’ll find that the ECB exerts far more control over events in Europe than the Fed does in the US.

For example, the ECB played a key role in the downfall of Italian Prime Minister Silvio Berlusconi. Since 2010, the ECB has had a program in which it can buy government bonds to help lower a country’s cost of funding.  When Italy’s bond yields rose to dangerously high levels in August 2011, the ECB intervened to buy Italian bonds but also sent a letter to Berlusconi demanding budget cuts and far-reaching reforms.  When Berlusconi failed to act with sufficient haste, the ECB eased off on its bond purchases, yields rose again to dangerously high levels and Berlusconi was forced to quit.

More obscure than the bond-buying program but far more powerful is the little-known “risk control framework”.  Normally, the ECB is willing to provide loans to banks as long as they can pledge assets that are listed on its “eligible collateral list”.   However, the risk control framework allows the ECB to deny credit to any bank or reject any assets as collateral should it see fit.  Specifically:

the Eurosystem may suspend or exclude counterparties’ access to monetary policy instruments on the grounds of prudence

and

the Eurosystem may also reject assets, limit the use of assets or apply supplementary haircuts to assets submitted as collateral in Eurosystem credit operations by specific counterparties.

The ECB has used the risk-control framework to control events at a number of key junctures in the euro crisis.

Ireland:  In late 2010, the Irish banks were under severe stress.  With international depositors pulling their money out, the banks became heavily dependent on the ECB for funding.  The Irish government has sufficient cash on hand to finance the country for about nine more months and was not seeking funds from the EU or IMF.  The ECB, however, was unhappy with the banking situation and decided Ireland should apply for program funds to sort out the banks.  So, after clearing their throats by revising the risk control framework with Ireland in mind, the framework was put to devastating use.  Faced with ECB threats to withdraw funding and thus trigger a full-scale banking meltdown, Ireland quickly agreed to enter an EU-IMF program.

Spain: By late May of this year, it had become clear to all that Spain’s banks needed substantial recapitalization, starting with Bankia, a recently-created conglomerate of a number of cajas.  The Spanish government decided that its preferred method for recapitalizing Bankia was to directly provide it with Spanish government bonds.  This approach is perfectly legal and would have been approved by Spain’s banking regulators.  However, the ECB didn’t like this approach and effectively vetoed it.   What gave it such a power of veto? The risk control framework.  ECB could simply threaten to refuse credit to Bankia thus triggering the type of crisis the recapitalization plans were attempting to avoid.  Since Spain could not raise the sums involved, this decision effectively forced Spain to apply to the EU for aid with recapitalising its banks.

Leveraging the EFSF\ESM: Perhaps the most powerful suggestion for easing the sovereign debt crisis has been Daniel Gros and Thomas Meyer’s proposal to provide Europe’s bailout funds with a banking licence, thus allowing them to borrow from the ECB.  This ESM bank could potentially purchase trillions of euros worth of government bonds and its existence would provide Italy and Spain with the kind of “bond buyer of last resort” that the Fed has provided for the US government and the Bank of England has provided for the UK government.

However, this plan currently stands little chance of getting off the ground because the ECB opposes it.  Now you might argue that the EU can go ahead and give its bailout funds a banking licence anyway and indeed they could do just that. But, by now, you know the tool that Mister Draghi can use to undermine this plan: The risk control framework. The ECB can simply refuse to accept the ESM bank as an “eligible counterparty”.

All told, the story of ECB’s serial use of its risk control framework raises pretty serious questions about whether it is has been a good idea for Europe to provide this much power to a single unaccountable institution.