Promissory Notes: No Magic Required

Here‘s an interesting article on promissory notes by Dan O’Brien of the Irish Times. Dan defends the ECB’s approach to this issue:

The ECB has been subject to criticism in this country for not letting Ireland off this portion of its debts. Difficult and all as it is for a taxpaying citizen of this State to concede, Frankfurt is entirely correct to refuse to magic away Ireland’s promissory notes.

Dan’s key argument is as follows

If the ECB was to delete some of Ireland’s debts at the click of a button, as some people advocate, it would not be long before other governments started issuing promissory notes and looking to Frankfurt for some monetising magic. Having the ECB make an exception for Ireland may seem appealing, but it could never be justified by a central bank serious about preserving the currency.

Thus, Dan sees the lightening of any debt burden as needing to be done via fiscal transfers of some sort

The monetary authority in Frankfurt has always insisted that any relief on Ireland’s bank debt is done by the fiscal authorities – i.e. other euro area governments collectively.

The moral case for doing this is very strong. In terms of the collective interest of the euro zone, the case is almost as strong – ensuring Ireland exits its bailout will benefit everyone. Easing the repayment terms on the promissory notes will help to achieve that.

In the event that an easing is not granted, criticism should be directed at those who deserve it. That would be other euro area countries, not the ECB.

The article is well argued but I don’t think the conclusions it arrives at are necessarily correct.

The point about magicking away the promissory notes is a straw man and it’s easy to win arguments with straw men. But it is a logical leap to go from accepting the notes won’t be magicked away to arguing that a restructuring of the notes within the current ELA arrangement is somehow impossible.

One can wave away arguments about a special deal as simply Irish exceptionalism that would set a precedent for everyone else to get such a deal. However, that misses the key fact that the IBRC promissory notes are an exceptional deal. Nowhere else in Europe has a country taken on debts of 20 percent of GDP to bail out an insolvent bank. Indeed, bank resolution proposal documents such as this one from the European Commission are partly premised on the idea that what happened in Ireland with Anglo is unacceptable and should not be repeated.

So the reality is that the promissory note\ELA deal involving IBRC is an exceptional one and one that the ECB Governing Council has agreed to. The ECB has taken a number of bold steps in recent months including radical changes to its collateral framework. Against this background, it should not be considered unimaginable that the collateral for IBRC’s ELA could have its payment structured altered.

The slippery slope on this issue is also a bit overplayed. The ECB’s mandate allows it to pursue a wide range of policies in support of the goals of the EU provided they do not “prejudice” its goal of price stability. Reworking the collateral on €28 billion of Eurosystem loans at a time when the system has just printed off €1 trillion hardly smacks of a systemic threat to price stability. But if other larger countries wished to print of large amounts of ELA in support of their banking systems, then clearly any decision on such proposals would have to keep price stability in mind.

I’m not saying that a final resolution of the promissory note issue won’t involve, for example, the government taking on a long-term loan from EFSF to allow the ELA loans to be repaid and the promissory notes retired. But it is not necessarily the only change from the current situation that would represent an improvement.

ELA is Printed, Not Borrowed

A member of the fourth estate passed on to me a “Background Briefing” from the government on promissory notes.

It contains the following sentence: “The Central Banks (sic) had to borrow this Cash to give to Anglo and has a resultant liability that it must repay.”

This is not true. ELA funds were not borrowed by the Central Bank from the ECB or the rest of the Eurosystem. They were created by the Central Bank of Ireland and provided as a credit to Anglo’s reserve account. To the extent that Anglo used this money to pay off people with foreign bank accounts, the liability will have switched from being a reserve liability to an Intra-Eurosystem (i.e. Target2) liability.

Furthermore, as central bank economists throughout Europe have been saying time and again over the past year (e.g. this piece by two Bundesbank economists) Target2 balances simply reflect the outcome of private decentralised transactions and there is no system whereby a Target2 creditor is under an obligation to “repay” the Target2 liabilities under any particular time-frame.

The long-winded version of this point is on page 14 of my recent briefing paper:

The reason I have described Intra-Eurosystem transactions in such detail is that there has been some confusion in media and political circles in relation to the nature of the ELA issuance.  A number of media stories have reported that “the ELA money was borrowed from the ECB”. This is not the case. The ECB does not issue money at all as this task is delegated in the Eurosystem to national central banks.

A more subtle version of the “ELA was borrowed from the ECB” claim was provided in an answer to a parliamentary question by the Irish Minister for Finance, Michael Noonan, on January 31, 2012. Mr. Noonan stated that “ELA is itself funded by the CBI through Intra-Eurosystem liabilities”.

The word “funded” can have an elastic meaning. However, this answer suggests an interpretation in which the appearance of an ELA asset on the Central Bank of Ireland’s balance sheet is accompanied by an increase in Intra-Eurosystem liabilities. It is my understanding that this is not the case. At the moment of “conception”, so to speak, of the ELA, the corresponding increase in liabilities is a credit to the reserve account of the bank receiving the ELA loans.  Only if that bank then uses its ELA funds to transfer money to bank accounts outside Ireland does the Central Bank of Ireland’s balance sheet start to show an increase in Intra-Eurosystem liabilities.

Because the IBRC appears to have used the vast majority of its ELA loans to pay off foreign bondholders and people moving their deposits outside of Ireland, there is little doubt that the issuance of ELA has led to a significant increase in the Central Bank’s Intra-Eurosystem liabilities. However, it is not accurate to describe the ELA as having been either “borrowed from the ECB” or to describe an increase in “Intra-Eurosystem Liabilities” as the source of the funds.

There are lots of reasons why the ELA needs to be repaid, so why persevere with this false one? As far as I can see, there are two possible explanations for the continued use of  this talking point. Either the officials who draft these briefing notes don’t understand how ELA works or else they do understand but feel that the “money was borrowed from the ECB” line will provide a good excuse on March 31.

Effect of Austerity Measures by Country

Here’s what I was referring to in the previous post when I recommended looking at a European Commission report. It’s a graph showing the effects of austerity measures on household disposable income by country. Ireland is the brown line. The original source of the chart is this European Commission report whose authors include Tim Callan from Ireland’s ESRI.

Exchange on Promissory Notes with an AAA-Rated Correspondent

This weekend, I received an email from an economist from a Triple AAA-rated Euro zone country in response to the briefing paper that I provided to the Oireachtas Finance committee. This person wished to keep their correspondence confidential so I’m not going to repeat their email. However, I think it might be useful to outline the nature of the exchange I had with them and to provide my response in public. While I don’t think this issue comes down to technical considerations, the exchange does shed some light on some of the technical matters likely being discussed behind the scenes.

My correspondent put forward a number of arguments.

  1. That Article 18.1 of the statute governing the ECB and Eurosystem says that lending from national central banks must be based on “adequate collateral” and that this applies to all lending, including ELA. They argued that the Eurosystem’s principles of collateral and haircuts should be considered “sacred”.
  2. That this means that the yield to maturity on promissory notes must be the same as the yield on marketable Irish government bonds, so any restructuring of the notes to reduce payments now must result in even higher payments later and this cannot help reduce Ireland’s debt burden.
  3. That publicly appealing to change the structure of the promissory notes amounted to the Irish government lobbying the ECB Governing Council to change its collateral policy, which undermined the Council’s independence, an issue which its members feel very strongly about.

In summary, my correspondent argued that a restructuring of the note that reduced Ireland’s debt burden was impossible and the Irish government arguing for such a restructuring would simply generate bad will among our European partners. The correspondent concluded by noting that they had nothing against the idea of some kind of deal aimed at reducing Ireland’s debt burden and made a brief reference to senior bank debt.

Here’s my response:

Dear X

I understand your arguments but I think this issue needs to be discussed in light of other recent events in the Eurosystem in recent months.

You may consider the practices of collateral valuation and haircuts to be sacred but you know that there has been a considerable shift in collateral policies over the past few years.  It’s a complicated crisis and lots of things previously considered unthinkable have happened.

You’re right that the Treaty mentions “adequate collateral” but it does not specify the meaning of “adequate”.  As I explained in my paper, it is my opinion that the letters of comfort and facility deeds provided to the Central Bank make the promissory notes different assets (more safe) than normal sovereign bonds which do not come with such assurances, so I don’t necessarily agree that they need to be valued in line with current Irish private bond rates.

You probably disagree with that argument but ultimately this is a judgment call for the Governing Council to make.  And now, with the GC having authorised €1 trillion in long-term loans, much of it against previously ineligible collateral, raising the question of a reworking of the collateral on a mere €28 billion is hardly unreasonable.

Even if you are right that the notes need to be valued using the current private bond rate, there is still some gain from a payment structure that backloads the repayments.  This would reduce the cash flow burden at a very sensitive time with Ireland attempting to return to the market to finance deficits and repay debts.  In addition, delaying payments on the note to a time when underlying fiscal retrenchment is over will allow for a smoother path of fiscal adjustment. (To understand the extent of adjustment so far in Ireland, I recommend page 20 of this PDF file of a Commission report on Ireland

I’d note that in recommending delaying payment on the notes, I am not recommending that ELA repayments cease. The IBRC is selling assets and taking in reasonably large quantities of loan payments. It has sufficient assets to repay much of the ELA over the next few years even if there were no promissory note payments over that period.

In relation to independence, I know how the Governing Council works and have always made clear to people in Ireland that any changes to the notes would need to be discussed among Eurosystem staff and then brought to the Council to be considered. This is not a matter of politicians lobbying for the notes to be changed and I would note that the Irish government have been extraordinarily low key in their approach to this issue, hardly ever mentioning the Governing Council. The discussions which are taking place are at a bureaucratic non-political level, though I don’t believe they are making any progress towards getting the notes changed.

Anyway, thank you for taking the time to engage on this issue. I will do my best to be clearer about the issues relating to collateral quality and ECB independence in future. It’s also good to hear you are not against lightening the debt burden for Ireland, though I would note that there is very little IBRC senior debt left (less than €1 billion) and it’s not really possible to consider restructuring the debt of the other banks which have now been recapitalised. So I think a reworking of the notes would be beneficial.

Regards and thanks,


ECB Governing Council Discussions

There have been a number of news stories in the past day or so (e.g. this one) which have noted that despite earlier stories flagging that Patrick Honohan was going to raise the issue of promissory notes at the ECB Governing Council meeting on Thursday, Mario Draghi said that it was not discussed at the meeting.

I think it’s probably worth pointing out that (at least as I understand it) the Governing Council members meet for dinner the night before the Thursday meeting and key issues often get discussed there so that when the actual meeting happens, the ECB President can say with a straight face in response to questions that certain issues were not even discussed at the meeting. It’s an old trick.

A better signal that, indeed, there is unlikely to be a re-working of the notes any time soon (or perhaps ever) was this story from the Irish Times written by Arthur Beesley, which is pretty clearly based on a briefing from an ECB insider (probably a high-ranking one).  Some of it is pretty painful, e.g.

Given that there is money available in the bailout plan to pay the €3.1 billion due on March 31st, the case is being made that any delay would seriously erode the Government’s standing with markets at a time when Ireland’s return to markets is still not assured.

The idea that sovereign bond investors are actually keen to see the government burn €3.1 billion a year on promissory note payments is fairly ludicrous.

This is also quite pointed:

Within the ECB, the view remains that alternative avenues are open to the Government to improve its finances, among them reductions in public sector pay and welfare entitlements.

The argument is made that average public pay and welfare levels in Ireland are higher than the average in some of the other euro zone countries that are supporting Ireland’s bailout, among them Spain, Slovenia and Slovakia.

I think there’s an element of apples and oranges here. Yes, more fiscal adjustment is required, and public sector pay and welfare rates are part of the mix. But the ultimate objective is to allow Ireland to finance itself independent of the EU and IMF and without some reduction of the burden of the existing debt, much of it bank-related, that probably isn’t going to happen.

Anyway, the key point is that if a deal doesn’t happen, it will be because the ECB Governing Council didn’t want a deal, not because Patrick Honohan failed to raise the issue.

Why Did Noonan Sign the ESM Treaty?

Nama Wine Lake asks “What did Michael Noonan get in return for an agreement which may leave this country stranded without practical funding options from 2013?” i.e. what did he get in return for signing a treaty that stated that Ireland could only obtain further bailout funds if it signed the fiscal compact?

Phrased that way the answer is clearly, “damn all”. Still, I’ll take up the challenge of answering a different question “Why Did Noonan Sign the ESM Treaty?”

The simple answer is that no matter how the game played out, Ireland wasn’t going to get further bailout funds without signing up for new fiscal rules. Since the Merkozy summit in August, Mrs. Merkel was determined that binding fiscal rules were required in the Eurozone as cover for whatever else she may have to agree to. So far, what she’s agreed to is less momentous than many imagined last Autumn (a slightly expanded ESM and not too much grumbling about LTROs and weakened collateral rules) but talk of Eurobonds or ESM-as-a-bank are usually only a wobble away (which reminds of this tweet.)

If Ireland had objected to signing a changed ESM Treaty with the “poison pill” clause about the need to have signed the Fiscal Compact, then I’m pretty sure the original ESM Treaty could just have been mothballed and a new institution put in place by a non-EU treaty just like the Compact.

Even if the old ESM Treaty could have been left unchanged, loans can only be dispensed by ESM if a qualified majority of member states approved. What chance Ireland’s appplication for funds succeeding if it was the country that wrecked Mrs. Merkel’s plans of quid pro quo?

I’m also not so sure that the addition of the poison pill clause was quite as secretive as NWL and Vincent Browne seem to think.

The idea that ESM access was the inducement for many countries to sign the new treaty was mentioned often enough in the run-up to December. The requirement for signing the Compact to access ESM was then mentioned in the preamble of the treaty text on January 31. In the subsequent days, Vincent treated his viewers to some classic monologues about how this claim that the Compact had to be signed to obtain ESM funds was a lie, a lie, a terrible monstrous lie. Only it wasn’t. Two days later, I posted the ESM Treaty on the Irish Economy blog here, noting that VB show viewers might be interested.

Irish governments have made some terrible mistakes in recent years. I don’t think signing the revised ESM Treaty was one of them.

ICTU Meeting on Fiscal Compact Treaty

This morning I attended a meeting of the Executive Council of the Irish Congress of Trade Unions to speak about the Fiscal Compact treaty (yes I did a presentation at IBEC on Wednesday and no, I’m not on a campaign to bring back social partnership.)

For once, I didn’t give a PowerPoint presentation (if PowerPoint makes you stupid, then I must be dim as a plank at this stage) but instead spoke from some notes, which you can find here.

I expanded on my opinion that, despite its flawed nature, Ireland’s best interests were served by signing the treaty. (Another speaker was more negative about whether ICTU should support the Treaty).

One issue I discussed (and will probably discuss more in the future) is whether there could be an EU or IMF-sponsored bailout if Ireland doesn’t sign the treaty and fails to regain market access. My sense is that there would be no political will in Europe for a bailout for a country that would not sign the Compact.

In relation to the IMF, I’d recommend people go to pages 98-100 of this report from December 2010.  You’ll see the following “Overall, the proposed access would entail substantial risks to the Fund. The Fund would be highly exposed to Ireland in terms of both the stock of outstanding credit and the projected debt service, for an extended period and in a context of high overall debt and debt service burdens.” An IMF-only deal for Ireland in 2013 would greatly magnify these risks. A small-scale sticking plaster deal following a large fiscal restructuring and a rapid austerity programme might be a possibility.

I don’t want to talk too much about the ICTU meeting but my sense from the questions I got (I left before any internal discussion) was that the attendees were considering the issues in a very thoughtful manner. It will be interesting to see how they decide to campaign.

Finally, I’d note that I’ve had some feedback from people confused by my “sign this flawed treaty” argument but all I can say is that this isn’t a simple black or white issue. And I’m prone to being a “shades of grey type” at the best of times.

Killing Public Debt, Not Keynes

The excellent Seamus Coffey has a useful post on the implications of the Fiscal Compact rules for the ability of governments to run counter-cyclical fiscal policy,

Seamus correctly points out that it is still possible to run counter-cyclical policy while maintaining a structural balance of 0.5 percent. Here’s Seamus’s example:

One could debate the specific figures in this example but the point is well made. The country in this example only breaks the 3 percent deficit limit when the output gap is 6 percent. That’s a fairly big output gap, as seen from the figure showing the CBO’s estimates of the US output gap. Interestingly, the IMF estimates 6 percent as the maximum output gap for Ireland (see page 26) because they view the pre-crash economy as having been well above its potential level.

So all is good with this fiscal rule, right? Well, let’s think about the debt-GDP ratio in this economy. In the long-run, the debt-GDP ratio for a country that has deficit ratio of d and a growth rate of nominal GDP of g will converge towards d/g. Here‘s a note providing this formally but it’s not so complicated: If we keep adding one unit of debt for every four units of GDP then our debt-GDP ratio is going to tend towards one-quarter.

The Fiscal Compact specifies that the maximum cyclically-adjusted budget deficit should be a maximum of one percent. In any economy that grows at a nominal rate of four percent (say two real, two nominal) this will imply a maximum debt-GDP ratio of 25 percent of GDP. A government that does not want to be constantly flirting with warnings from the Commission or its own national budgetary body set up to enforce the Compact, will probably shy away from going too close to the one percent, so in practice these rules would send the economy on a path towards the elimination of public debt.

So while the Treaty may not kill Keynes, you could argue that it does attempt to kill public debt.

It is in this context that I have argued that the rule place limits on the sensible usage of counter-cyclical fiscal policy. In my recent VoxEU article on this topic, I said that the “rules will also severely limit the ability to use fiscal policies for stabilisation purposes in a manner consistent with moderate long-run debt levels.” The qualifier about moderate debt levels is important.

Consider Seamus’s example. Suppose a country with a nominal GDP growth rate of four percent had a government that wanted to stabilise its debt-GDP ratio at 60 percent.  This country could run an average deficit of 2.4 percent. In Seamus’s example, such a country would pass the 3 percent deficit limit as soon as there was an output gap of 1.2 percent, which is smaller than is triggered in almost every recession.

An alternative and consistent set of rules that focused on keeping debt ratios stable at 60 percent would, using Seamus’s theoretical figures, allowed this country to run a deficit of 5.4 percent at the bottom of the cycle when the gap is 6 percent and then to run a surplus of 0.6 percent at the top of the cycle when the gap is a negative 6 percent.

The underlying premise of the figures used to implement the proposed “golden rule” seems to be that “public debt is bad”.  Now I don’t want to go all MMT here but it’s not a huge insight that one person’s debt is another person’s asset. One has to wonder have the designers of these rule thought about the future structure of the economy, what pensions funds and other savings vehicles are supposed to use instead of government bonds and what the world looks like when public sector and private sector are both attempting to reduce their debt levels over time.

One might quibble with objections to the Compact rules based on their very long-run implications, when we know from Keynes what happens in the long run. However, the implications are not just short-run.

For example, consider the Netherlands. This country looks very like my stylised “well behaved” country above. According to the EU Commission, the Netherlands had a cyclically adjusted budget deficit of 2.5 percent in 2011 and it tends to grow at an average real rate of 2 percent, consistent with 4 percent nominal growth. Its debt ratio in 2011 was 64 percent.

So this country is doing just fine: They are on a course consistent with a stable debt ratio of about 60 percent. Yet the Fiscal Compact rules will insist that they reduce their deficit by a further two percentage points over the next few years. This example can be repeated across other countries to varying degrees. The point is that the new rules are likely to mean tighter fiscal policy in Europe than is necessary in the coming years, something that will make it all the harder for those countries that need to undertake fiscal retrenchment to obtain the growth required to reduce their debt ratios.

And even if the implications were only long-run, a treaty isn’t just for Christmas. It’s something that, once signed, we will be stuck with for a long time.  While the self-interest of countries like Ireland may be best served by signing up for this flawed treaty, the wider European public should focus on getting us a better treaty before this one comes into force.