My latest thoughts: Is Draghi really going to save the euro after this week’s events.
I’ve updated my TARGET2 paper. Here is a post with a link to the new paper and a discussion relating to a potential exit of Cyprus from the euro.
Despite the absence of any panic today at European banks or in financial markets, I believe this weekend’s decision on Cyprus may cause serious trouble in the coming weeks and months. Comments here.
A quick reaction to the Cyprus deposit levy here.
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.
A post about the disappearance of IBRC’s equity that occurred via the promissory note bond swap.
Olli Rehn is the European Commissioner for economics. Olli has spent much of his time in recent years telling everyone that Europe’s austerity policies were working and the Eurozone economy was just about to turn the corner. In reality, the Eurozone has been in recession since the third quarter of 2011 and the recession appears to be deepening: Eurostat this week reported a decline of 0.6 percent in real GDP in the final quarter of 2012.
This week, Olli sent a letter to the EU’s finance ministers and other luminaries including IMF managing director Christine Lagarde. So what was on Olli’s mind? Concern about the ongoing slump? Worries about record high unemployment? No. It turns out Olli is worried that IMF economists are doing research on fiscal multipliers.
Last year, IMF Chief economist Olivier Blanchard released a paper co-authored with Daniel Leigh examining the impact of fiscal austerity (Full disclosure: Blanchard was my PhD supervisor). They compared the IMF’s forecast errors for GDP growth in recent years with plans for fiscal consolidation.
The paper found a negative relationship between fiscal consolidation and growth forecast errors and concluded that fiscal multipliers during the crisis must have been larger than had been assumed. In other words, austerity has had more negative effects than the IMF had previously assumed.
Olli isn’t happy that this research has been released. His letter says that this debate
has not been helpful and has risked to erode the confidence that we have painstakingly built up over the past years in numerous late-night meetings.
Even leaving aside the medieval prince aspects of these comments (“Galileo needs to stop undermining confidence in the Ptolemaic system”) can Olli really believe that Europe’s finance ministers have been building up confidence while the economy languishes in recession?
Olli’s letter then launches into an amateur referee report on the Blanchard-Leigh paper. His first critique of their result is that the actual amount of fiscal consolidation was larger than planned, so the IMF paper is over-estimating fiscal multipliers. However, pages 13 and 14 of the paper contains a detailed discussion of this issue and concludes “on average, actual consolidation was neither smaller nor larger than expected.” So, as far as I can tell, this issue was dealt with in the original analysis.
Olli’s second critique stems from the fact that the largest growth shortfalls occurred in 2010 when many countries were still implementing temporary fiscal stimulus. He asserts (without providing any evidence) that permanent consolidation is associated with lower fiscal multipliers, suggesting that the kind of fiscal consolidation that occurred in Europe in 2011 and 2012 will not have contributed to unexpectedly low growth. But Figure 2 of the Blanchard-Leigh paper also shows strong negative relationships between fiscal consolidation and growth forecast errors for 2011 and 2012 so this point does not appear correct.
In terms of who to believe here, you can choose to trust Olli the Confidence Man who believes debate about fiscal policy is unhelpful or the IMF’s chief economist who also happens to be the world’s tenth best economics researcher. I know who my money is on.
Ding dong the wicked bank is dead. Anglo Irish Bank is no more. Its successor, the Irish Bank Resolution Corporation is being liquidated. Unfortunately, its legacy of debt piled on the Irish public’s shoulders is not dead. Still, last Thursday’s announcement, which saw the infamous promissory notes replaced with a series of very long-term bonds, is a useful step in reducing the burden associated with the IBRC. Credit is due, in particular, to the Central Bank of Ireland Governor, Patrick Honohan, who oversaw new arrangements being put in place that secured the approval of the ECB Governing Council.
In this post, I discuss the new arrangement and put some numbers on its benefits. I also discuss some of the objections to the deal that have been raised in Ireland and conclude with a discussion of some of the legal issues considered by the ECB when approving the deal.
IBRC was created from merging two institutions that had borrowed extraordinary amounts of money under an Extraordinary Liquidity Assistance (ELA) program from the Central Bank of Ireland to pay off creditors. This money was created with the approval of the Governing Council of the ECB. The Irish government provided guarantees to the Central Bank of Ireland that these loans to the state-owned IBRC would be repaid. The repayments would see the money created by the original loans taken out of existence.
To allow the IBRC to repay its loans (and to provide collateral for those loans) the Irish government agreed in 2010 to provide it with so-called “promissory notes”. These notes provided the bank with payments of €3.1 billion per year over the next decade from the Irish government, approximately 2 percent of Irish GDP each year. In calculations I reported here before, I estimated that IBRC would have paid off its debts to the Central Bank by 2022. While the promissory notes had additional payments scheduled for years after 2022, these payments could have been cancelled and the bank liquidated.
Instead, the IBRC was liquidated last week. However, rather than the Central Bank of Ireland taking possession of the promissory notes, an agreement was reached to rip up the promissory notes and instead provide the Central Bank with €25 billion in new very long-dated bonds.
The New Bonds
As described here, the new bonds have maturities ranging from 27 years to 40 years with a weighted-average maturity of 34.5. So this means no repayment of principal on these bonds for 27 years. The bonds carry a variable interest rate that tracks six-month Euribor rates with an average additional margin of 263 basis points.
The impact of these interest payments on the cost of the transaction will change over time. At first, the bonds will belong to the Central Bank of Ireland. However, the Central Bank hands back its surplus income to the Irish Exchequer, so these interest payments can be considered a circular transaction in which interest is handed over to the Central Bank to eventually be handed back to the Irish government.
Crucially, however, the Central Bank of Ireland has agreed to dispose of the bonds over time by selling them to the private sector. This will gradually increase the amount of interest that is being paid out and not simply returned by the Central Bank. A presentation from the Department of Finance states:
The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.)
If this minimum amount of sales is stuck to then it will take until 2032 for all the bonds to be in private hands. On Irish television on Sunday, however, Patrick Honohan said the bonds would be sold “as soon as possible” but also said he didn’t see pressure from the ECB being applied to force a quicker pace of sales than the minimum agreed last week.
The fact that the bonds need to be sold to the private sector (and at an uncertain pace) means that claims that the deal “pushes the cost out over 40 years at low interest rates” are not entirely correct.
If the Irish government was able to borrow large amounts of money now over 40 years at Euribor plus 263 basis points then they would have done so and used the money to retire the promissory notes and liquidate IBRC. At present, we can have no guarantee that the sales of these bonds will occur at par value. If private investors in the future are only willing to purchase these bonds at higher yields than the Euribor-plus-263bp coupons, then the Irish government (in the form of its Central Bank) will incur a loss on these sales. So while it turns out the new arrangements place a far lower burden on Irish taxpayers over the next few years, they don’t “kick the can” of refinancing the IBRC debt quite as far down the road as many have been assuming.
Here is a spreadsheet that I’ve put together that allows for a comparison of the new arrangements involving €25 billion in new bonds with how this €25 billion would have been paid off under the previous promissory note structure. The calculations of the annual cost of the promissory notes are along the lines of those reported in my post from last November.
Importantly, the spreadsheet assumes that bond sales correspond to the minimum described above, so the estimated benefits will be lower if the bond sales are faster. It also assumes that the sales of private bonds will occur at par value and won’t add to the estimated costs. Future Euribor rates up to 2024 are estimated by deriving forward rates from the mid-swaps interest rates reported in Friday’s Financial Times and then held constant for subsequent years.
A summary of the calculations:
- The promissory notes would have paid off the €25 billion in 10 years, meaning an average net cost of €2.5 billion over the next decade. This is lower than the annual €3.1 payment because some of the payments would have taken the form of interest payments to the Central Bank which could have been returned to the government.
- In stark contrast, the total net payments under the new arrangements over the first decade are only €1.4 billion. While I project €11.2 billion in total interest payments through 2022, all but this €1.4 billion go to the Central Bank. In this sense, the new arrangements provide a very substantial relief over the next decade relative to the previous ones.
- Slightly less positive is the fact that €6.5 billion in long-term bonds must be sold up to 2022. From the point of view of financial markets, these sales will be treated in pretty much the same way as new bond sales. They represent the Irish public sector incurring a new debt to the private sector. So the new arrangement leads to financing demands of €7.9 billion over the next decade (€1.4 billion to pay the interest and €6.5 billion in bond sales) relative to €25 billion required under the promissory notes.
- After 2022, the new arrangements become more demanding. The decade 2023-2032 sees €9.6 billion in interest payments to the private sector and €18.5 billion in bond sales. The decade 2033-2042 sees €13.8 billion in interest payments and €4 billion in principal payments. Finally, 2043-2053 sees interest payments of €7.36 and €21 billion in principal payments.
There are a number of ways to think about the benefits of the new arrangements.
- With the public debt ratio now over 122 percent and investors potentially concerned about the prospects of sovereign debt restructuring taking place if the debt ratio cannot be stabilized, the dramatic reduction in financing requirements over the next decade is helpful. It reduces the chances of a sovereign default triggered by inability to meet payment demands to the private sector.
- More generally, delaying payments off into the future allows them to be dealt with at a time when inflation and economic growth have reduced the burden they impose. For example, the final two principal payments of a combined €10 billion will occur in 2051 and 2053. If made today, these payments would account for 6.25 percent of Irish GDP. However, if nominal GDP grows at 4 percent per annum over the next 40 years, these payments would be closer to 1 percent of the GDP at the time of the payment, making it far easier to simply roll this debt over.
- One way to calculate the reduced burden due to delaying payments is to calculate the net present value (NPV) of the stream of payments. The spreadsheet uses a 6 percent per annum discount rate and calculates the NPV of the promissory note payments as 19.5 billion and the NPV of payments under the new bonds as €12.8 billion. This represents a 34.4 percent reduction in the NPV. While clearly some way short of a full write-off, last week’s deal still represents a clear improvement on the promissory notes.
Objections to the Deal
Some of the reaction to the deal in Ireland has been negative. Some have criticized the new arrangements because they don’t involve a full write-off of the IBRC’s debt. However, the European Treaty’s outlawing of “monetary financing” makes it clear that loans from central banks to state-owned banks can’t simply be written off and there was never any chance whatsoever that such a write-off could have emerged from negotiations with the ECB. Those with moral objections to the nature of this debt should consider whether the Irish authorities should have rejected a deal that reduced the burden of the debt because of the absence of an unattainable deal.
A second objection has been the idea that the deal simply “kicks the can down the road” or (more emotionally) “forces our children and grandchildren to pay off huge debts”. Well public debt rarely ever gets paid off. Instead it is rolled over as long as financial markets believe governments have the capacity to honor their debts. Unless economic growth and inflation come to an end (in which case the Irish people will have a lot more than IBRC debt to worry about) future generations of Irish taxpayers should be able to roll over these debts (Though before Ireland’s children all grow up and have children of their own, the country will face the challenge of selling large quantities of the new bonds next decade without generating losses).
A final objection that has been widely aired is that by replacing the promissory notes with new bonds, the Irish government has taken something that wasn’t sovereign debt and replaced it with sovereign debt that must be honoured in some way that the promissory notes didn’t have to be. I have no idea why people believe this. The promissory notes were debts issued by the Irish sovereign, hence they were sovereign debt. And they were counted as sovereign debt by Eurostat, the official arbiter of these matters in Europe.
It is possible that people have had in mind that the promissory notes could be cancelled if Ireland left the euro and so was no longer subject to the monetary financing prohibition. However, if a euro exit was to occur at some point in the next few years, there would be nothing preventing the Central Bank of Ireland from cancelling the new bonds or indicating it would roll them over forever and hand back all interest payments. In fact, because the transition to the bonds being held in private hands in the new arrangement is slower than the repayment of ELA under the old arrangement, the flexibility to cancel or default on these obligations in a crisis scenario is more significant than it was previously.
A final question is whether the IBRC’s previous funding or the current arrangements constitute a violation of the European Treaty’s prohibition of monetary financing. This is probably worth a separate discussion of its own and I may return to it. For now, let’s take a look at the relevant section of the Treaty (Article 123)
1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.
The promissory note arrangements could have been considered a violation of Article 123.2. While it was legal for the Eurosystem to loan money to the IBRC, it was questionable as to whether it was receiving the same treatment as other banks.
ELA loans are generally intended to be provided for a short period of time while emergency measures are taken to save or liquidate a bank. However, IBRC was going to take at least 10 more years to pay off its ELA loans. Furthermore, it was using a non-marketable instrument (the promissory notes) to provide collateral against these loans. IBRC did pay a risk premium on its ELA loans but the profits the Central Bank made from these premium payments were returned to the government.
All told, the IBRC arrangements could have been considered monetary financing. However, no legal case was ever taken against it. The ECB Governing Council could have shut down the ELA operation using its powers under Article 14 of the ECB statute. However, they consistently approved the operation and one could argue that if a ten-year repayment was legal, then a forty-year repayment could also have been legal. The Article itself isn’t exactly prescriptive on which loans terms are or are not legal.
Anyway, for one reason or another, it was decided to scrap the IBRC altogether and provide replacement bonds to the Central Bank of Ireland. Now the question is whether the new arrangements violate Article 123.1. This article forbids the direct purchase of government bonds by central banks in the Eurosystem.
The CBI has ended up with €25 billion of Irish government bonds, which would be exactly the outcome had they violated the Treaty and directly purchased the bonds. However, because the bonds ended up at the CBI indirectly because of the liquidation of IBRC, it can be argued that last week’s exercise was not monetary financing.
A separate question is whether the current arrangement constitutes a “type of credit facility”. Mario Draghi says that the Governing Council members “took note” of the last week’s events in Ireland. Their reluctance to do any more than take note suggests that the Governing Council members don’t believe the new arrangements are monetary financing.
It’s worth pointing out that the “indirect route” by which the Central Bank has ended up owning these bonds didn’t exactly involve an Act of God by which the Bank ended up holding them accidently. The official story is that IBRC was put into liquidation because a Reuters story reported the government was considering liquidating the bank and this rendered the bank unstable. The reality is the IBRC was liquidated because the Irish government preferred the new arrangements that emerged as a result.
On balance, I’m inclined to agree with Wolfgang Munchau that the current arrangements are monetary financing in spirit if not necessarily according to the letter of the law. And like Munchau, I have no great problem with this. A weakening of unnecessary monetary purity may be required if the euro is to be saved.
Update: Alternative Bond Sale Scenario
I have put up a new spreadsheet that illustrates the scenario in which the Central Bank of Ireland sells all €25 billion of its bonds by 2022. This is one possible scenario as to what might be meant by “as soon as possible”.
The spreadsheet shows that this faster pace of sales would undo nearly all the gains associated with minimum-sales scenario. In addition to requiring the Irish public sector to find buyers over the next decade for €25 billion in long-dated Irish notes carrying coupons with modest spreads (a funding requirement not so different from what would have been required with the promissory notes) the net present value gain from the new arrangement falls from 34.4 percent to 6.1 percent.
These calculations show that the benefits from last week’s announcements are fairly uncertain and will likely depend upon future negotiations between the Central Bank of Ireland and the ECB Governing Council as to the appropriate speed at which the bonds should be sold.