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Tuesday, February 24, 2015

EuroGroup - Money For Nothing And Your Debt For Free?

There's an interesting question about "analysis" which confronts anyone who seriously wants to engage in it: do you organize your focus around what you want to happen (practical policy emphasis) or do you concentrate your efforts in detailing and outlining what you think will happen? Naturally the closer you are to having an ideological discourse the harder this distinction is to either see or maintain. But even for "non ideological" thinking the issue is far from being an easy one. Whether or not there is any such thing as "objectivity" is a complex philosophical question and attempts to achieve it fraught with all manner of difficulty, but surely we at least have to try?

I raise this point, because while those who write what is called "sell side" analysis do no more (and no less) than the name suggests - no one would really think such work was either objective or independent - we shouldn't abandon too easily the objective as being unattainable.

The issue becomes even more complex when you consider just how major multilateral institutions like the EU Commission and the IMF have steadily shifted their role since the start of the financial crisis, away from independent criticism and towards "talking up" troubled economies who are under their guidance. I think Larry Summers presented this issue nicely in his IMF research conference speech when he said:
"I agree with the vast majority of what has just been said [by Ben Bernanke, Stan Fischer and Ken Rogoff] – the importance of moving rapidly; the importance of providing liquidity decisively; the importance of not allowing financial problems to languish; the importance of erecting sound and comprehensive frameworks to prevent future crises. Were I a member of the official sector, I would discourse at some length on each of those themes in a sound way, or in what I would hope would be a sound way. But, I’m not part of the official sector, so I’m not going to talk about any of that."
Ever since Robert Lucas shifted attention in economic theory towards the role played by expectations, the artist has somehow been painted into the very picture he or she is painting. You can't talk about a topic without in some way changing the understanding (expectations about) the phenomenon in question. If you write, for example, that the Euro Area is stuck in deflation, doesn't that somehow add to the expectation that it may be?

 But there is another issue, and it's not simply about objectivity or bias, it's about communication, and about what others are prepared (or able) to think about (contemplate) at any particular point in time. I had my own personal problem with this just last week, when I wrote a lengthy post on the so called "good deflation" phenomenon in Spain. I personally think - for reasons which will emerge below - that contemporary deflation is substantially different from the depression-related deflation we saw in the United States in the 1930's, the phenomenon around which much of modern economic theory on the topic cut its teeth. There is a very big difference between a 1% fall in prices every year for 15 years (the Japan experience) and a 15% fall in one year. Modern deflation seems more related to a structural weakness in domestic demand and investment associated with shifting demographic dynamics than it is to ongoing debt deflation, although many would be inclined to deny this.

But is the tendency towards denial based on intensive empirical study of the modern deflation phenomenon, or is it driven by the fact that if the problem is largely demographic then it has no evident solution. This is how the need to do policy can frame analysis, since the objective (sound policy) governs the analysis, indirectly  making the practitioner more inclined toward one hypothesis rather than another.

I personally hold the opinion that modern deflation largely has demographic roots, and basically think policy should come to be about learning to live it, and about how to manage our economies in such a context, rather than continually attempting to escape (Abenomics) from a phenomenon from which there is - in all probability - no escape. That is the approach which characterizes my work on Japan.

But in Spain the debate is at a different point. Whereas in Japan there is a live and ongoing discussion about whether the country should be doing Abenomics or not,  the majority of policymakers and sell-side people in Spain have not reached this point. They are still essentially arguing either that i) the country isn't in deflation, or ii) even if it is, Spain's deflation is of the "good" kind. As a result I ended up writing a piece which argues that Spain is in deflation (and has been for longer than most people imagine) and which explains that - as Tobias Buck described it in his tweet on the piece - "There is nothing good about deflation in Spain".

But if there's nothing "good" about the phenomenon, you might imagine I was suggesting doing something about it, like implementing QE at the ECB, for example. Well basically, if you thought that you would be wrong. I think there is nothing good about Spain's deflation, but that this is what there is. Not a perfect world, and it isn't my objective at this point to go into why people so often seem to imagine it could be. But naturally, if something is "bad" then from a policy perspective you should be looking for a solution, and the solution that's up and coming on the current agenda would be ECB QE. And if you think certain kinds of policy outcomes are likely then it becomes interesting to ask what the world will look like if the policy is implemented, even if you personally don't believe in its efficacy in terms of declared objectives, and this is what I am trying to do in this post.

What I want to look at are the implications of having ongoing deflation and increasing QE at the ECB (both of these contingent but empirically verifiable conditions) for the balance of calculation about whether or not a given country is better off staying in the Eurozone or leaving it. In other words, its a kind of thought experiment based on plausible assumptions: that deflation is demographically driven and that the ECB will continue to implement QE (or QQE) in a (forlorn) attempt to bring it to a halt. I think this kind of line of thought is worth pursuing since it will give us some idea of the kind of world we may be living in 10 years hence and move us on a bit from scrutinizing every piece of communication to determine whether the list of reforms proposed by the Greek government will be acceptable to the German one. Or whether the Greek government will have to meet its short term financing needs by issuing T-bills, or will the ECB will agree to advance the 1.9 billion Euros interest rebate which is pending? Sometimes we need to look beyond the end of our noses.

What Greece Needs Is It's Own Currency?

Judging by what runs through my Twitter feed,  I can't help getting the impression that most London based investors still have a line on debt, currencies and interest rate policy which hasn't evolved that much since the 1990s. The over-riding assumption is the Euro is overvalued for Greece's needs, that having your own currency and being able to implement your "own" monetary policy carry strong benefits, ones which far outweigh - for example - losing the anchor which is provided by an EU promoted structural reforms programme.

That the Euro was set up with major - almost fatal - institutional deficiencies is obvious, possibly now to everyone. Ditto for the fact that for many of the countries who participated in the experiment the balance of the first decade is in all  probability negative. Ditto that the single size monetary policy was manifestly applied counter to the interests of a number of economies on the periphery, economies which subsequently got into a great deal of difficulty.

But the question that really is crying out to be asked is: "has anything relevant changed"? Is there no difference between the world of 1995 and that of 2015? I personally think there is, and that the changes that have occurred can alter how we think about the whole question of Euro Area membership. Possibly to the extent of being able to understand why it is very much not in the interest of the Greeks to exit the currency at this point.

There are a number of features of our current economic and financial environment which make the world a very different place now to the one we used to live in back in the 1990s. These would be:  i) the rise of financial globalization, ii) the arrival of deflation in a number of developed economies and iii) the limitations placed on standard interest rate policy by the existence of the Zero Bound and the rise of non-standard measures, in particular QE.

There is a fourth and separate point - the existence of accumulated sunk costs - which also enter into any calculation about the difference between deciding to join and deciding to leave, but this one has been widely covered in earlier debates about Grexit, so can be treated to some extent as "shared knowledge".

QE at the ECB

January's decision by the Governing Council of the ECB to initiate a series of sovereign bond purchases as part of more general programme of quantitative easing, is historic and its significance goes well beyond immediate deflation concerns. The modality of the programme is more or less as follows:

i) there will be 50 billion Euros in sovereign purchases every month from March 2015 to September 2016 plus 10 billion Euros more under the existing asset backed securities and covered bond programme.
ii) purchases will be from the secondary not primary market (something the European Court of Justice opinion highlighted as important in any ECB programme).
iii) 12% of the 50 billion Euro monthly purchases will be of EU and EU institution securities.
iv) the purchasing will be done by the national central banks and will be in proportion to the capital key share of each country.
v) only 20% of the additional asset purchases will be subject to risk sharing.

This is a large programme, which will produce an increase of around a trillion Euros in the ECB balance sheet. The decision to warehouse 80% of the additional purchases at the national central banks has attracted a lot of attention, since it is clear that this procedure falls well short of full financial integration. The other side of the coin, though, is that it makes the cost of leaving the Euro much higher, since the part of the debt which will be held at the national central bank will effectively be virtually interest free as long as the country is in the Eurosystem (see below) whilst outside the Eurosystem framework such a programme would almost certainly be impossible to implement, and market based  interest rates would be above current ones.

If you are a country with no debt, then maybe life outside the Euro would be beneficial (maybe, there are other considerations), but if you have legacy debts (even restructured ones) then in the context of evolving QE (and there is a long, long way that the ECB can go with this over time) it can only be more expensive for you to find yourself outside. This is so whether you are looking at things from a purely debt sustainability point of view, or from an indebtedness as a drag on growth one. What makes the difference? The arrival of deflation is what makes the difference, since it is this that enables a central bank with deep pockets to increase its balance sheet almost indefinitely with generating inflation. And it is this deflation aspect which makes ECB QE so different from that practiced in the UK or the US, and so similar to what is going on in Japan.

Long Term Disinflationary Trend

Many argue that the current deflation in Europe is simply the result of a short term energy price shock, but as this chart presented by Larry Summers illustrates in support of his secular stagnation hypothesis  illustrates the trend towards negative rates has been a long lasting one.

As has the trend towards lower (and eventually negative) government bond yields.

And inflation in many developed countries has been on a secular downward trend running across decades, as this Swiss CPI chart shows.

So something is happening, and that something evidently isn't simply transitory and energy related. Here's Spanish consumer inflation with the energy component stripped out.

And here's a constant tax (ie without impact of consumer tax hikes) consumer inflation without energy chart.

It should be clear from an examination of these charts that there is a strong underlying deflationary trend in Spain (and by implication in the other economies on the southern periphery). This deflation is the result of weak consumer demand, and the impact of this on investment. In addition, this "deflationary moment" coincides with the turning point in working age population dynamics, entailing the possibility that we will see long term deflation, Japanese style. (For more on Spanish deflation see this post).

If we are seeing the arrival of long term structural deflation, and with it a process know as secular stagnation (Larry Summer's hypothesis), then the policy of Quantitative Easing recently adopted by the ECB will not be short term in duration, nor will interest rates in Europe move far in the foreseeable future from what has become known as the Zero Bound.

Certainly the bank of Japan has not been shy in increasing it's balance sheet.

Yet despite the extensive and ample use of QE and a 40% devaluation in the yen against the US dollar, ex-tax inflation in Japan has been steadily falling back and in December it was down to an annual 0.5%. So obvious is the failure of the policy to really produce sustainable inflation that Shizo Abe policy adviser Koichi Hamada recently argued that the government could cut the inflation target in half (from 2% to 1%) without any major loss of credibility.

So it is far from clear that the ECB's attempts to obtain its price stability target of near to 2% inflation will be successful, although the view you take on the issue will depend on what you think the underlying reason for the deflation really is. This inflation quandary is important since meeting its price stability objective is Mario Draghi's principal justification for introducing sovereign bond purchases under quantitative easing. Indeed Mr Draghi has even stated that far from such purchases not being within the banks mandate, not conducting such purchases (or similar policies) would be illegal under the mandate given its price stability objective.

So, since QE has been introduced until at least September 2016 the possibility exists that it will be continued beyond that point. Indeed it's hard to see how it won't be. And this difficulty in terminating QE will not only relate to inflation insufficiency, debt sustainability will also form part of the picture. Let's take an example.

QE and the French Deficit

The ECB has announced that 50 billion Euros in government bond purchases will be conducted monthly between March 2015 and September 2016. That means a total of around 900 billion Euros. Of these purchases 12% - ie around 100 billion Euros worth - will be purchases of EU institution instruments (not national government ones). So total sovereign bond purchases will be around 800 billion Euros. These will be bought by ECB (or national central banks) in proportion to Euro Area GDP shares.

Now France accounts for around 20% of EA GDP. So we should expect about 160 billion Euros in French bond purchases during 2015/2016. At the same time, the French government deficit is around 4% of French GDP, or an annual 90 billion Euros a year. The conclusion is that the vast majority of this new deficit will be effectively bought by the ECB. Not only that, this debt will be essentially free of interest service charges, since under the seigniorage principal, the French government will recover the interest paid to the ECB (or the national central bank). Obviously this is what I call "money for nothing and your debt for free".

So far, so good. The ECJ gave the opinion that this didn't amount to debt monetization as long as the purchases clearly took place in the secondary market. But let's think about the longer term implications.

Once You Are In QE How the Hell Do You Get Out?

As is widely know, Japanese gross government debt currently constitutes around 245% of Japan GDP. About 30% of that (or 80% of Japan GDPs worth) is now in the hands of the Bank of Japan. This - as explained above - now effectively costs the Japanese government nothing more than the admin costs of handling so many bonds. The proportion of GDP the BoJ stock of bonds constitutes is rising by the month. The other part of the debt (in private hands) costs, thanks to Japanese QQE, very little to maintain as yields have been driven to a very low level (0.4% on 10 year at the time of writing).

Now let's imagine that at some point the Bank of Japan ends QQE. (This again is what is normally called a thought experiment, since if I am right  it simply won't happen). In the first place Japanese bond yields would start to rise on new debt issuance sold to the private sector, while the part of the debt which is "for free" would become less and less as BoJ holdings steadily mature. The debt, remember is very large. This move would constitute an ongoing fiscal tightening (over several years) since interest service debt costs rising would mean less revenue available for government spending, or less demand in the economy. This tightening would almost certainly provoke a relapse of the fragile Japanese economy and most likely induce a return to deflation (if, that is, Japan  had ever really managed to leave).

It seems clear to me at least that Japan can now never completely exit some form of QE, at least it can't do so without going through a major restructuring of its sovereign debt, and a major shake up in its financial system.

Going's On Behind The Veil Of Financial Ignorance

Now lets turn to Europe, and Greece: the country with the second highest gross sovereign debt level globally (175% of GDP). Now the change in government in Greece has bought to the headlines the fact that this sort of debt level is not sustainable, unless someone else makes your debt effectively interest free. The Greek finance minister wanted to declare the country bankrupt, and accept the debt could not be paid. But the Euro Area partners rejected this, and preferred to maintain the fiction of sustainability. More money for nothing and your debt for free is the solution that has been found to maintain that fiction.  The significance of the recent Greek deal is that things are essentially going to remain that way.

In a speech given in Athens last year, ECB Executive Board member Benoît Cœuré,referred to Rousseau's "veil of ignorance" initial condition for agreeing on a social or fiscal contract, but maybe more to the point would be the "veil of financial ignorance" which surrounds EU decision making, and effectively means the majority of citizens have little idea of what is really going on. Some even talk of "protecting taxpayers' money in Greece" in relation to the EFSF loans, as if some actual money -rather than debt instruments and guarantees - had changed hands. Greece isn't going to pay back its debt to the official sector, nor will Euro partners ever have to recognise losses on money they haven't actually leant: the ECB can buy EFSF bonds to the appropriate amount and the matter will rest there, possibly with the bonds being renewed every 20, 30 or even 50 years.

So then work down the queue, to Portugal and Italy with gross sovereign debt levels of around 130% of GDP and rising.These debt levels are not sustainable either, unless that is someone is going to relieve you of your interest service charges, in which case such debt becomes merely an accounting problem. Enter the ECB.

But for the same reason I mentioned in the Japanese case, once the central bank has bought sufficient quantities of this debt, I simply don't see how we can ever move back to the initial position, without at least serious debt restructuring. The respective economies simply couldn't stand it. Italy's long run trend growth rate is nearly negative, and Portugal's isn't much better.

All of this will make policymakers in Portugal and Italy very wary of any kind of Euro exit, and increasingly so as debt levels and ECB bond purchases increase.

Favorable Winds Move All Boats

The Euro crisis has come a long way since the heady days of May 2010. A large part of the transition which has taken place has been the responsibility of one man: Mario Draghi. First through his "whatever it takes" speech of July 2012, which marked a watershed in the crisis, opening the period of declining sovereign bond yields. And secondly in a key speech made at the central bankers forum in Jackson Hole in August 2014.  This speech - which was actually rewritten during the gathering with the ECB having to amend the original version on its website - was historic in that it was the first time the ECB President explicitly recognized that Euro Area 5 year inflation expectations were not "well anchored". It thus paved the way for the eventual introduction of QE.

The speech was also important since he laid down a three point plan:

i) monetary easing at the central bank
ii) structural reforms by national governments
iii) expansionary fiscal policy in those countries which had "fiscal space" - ie capacity to run higher deficits.

This plan looks very much like a Euro-specific version of Abenomics "light". Progress has been made  on the first two points, but so far the response from Germany on the third item has been less than negative. In fact the country is proudly paying down its debt. Without taking this situation into account it is impossible to understand what has happened over the last few days with regard to the Greek bailout negotiations.

Billed widely in the press as a "great" victory for Germany, and a major humiliation for Syriza the outcome is in fact neither. The main victors (if such a name be relevant) have been - oh irony of ironies - the Troika (henceforth known as "the institutions"). In fact we are talking about the ECB (Mario Draghi), the IMF (Christine Lagarde) and the EU Commission (Jean Claude Juncker). There is basic agreement between the leaders of these three institutions that Greece was subjected to excessive austerity at the time of its first programme (the IMF have even made self-criticism over this), and that at a time of extended low inflation/deflation and worries about the settling in of deflation expectations further austerity is inappropriate.

Draghi's Jackson Hole plan is in reality the plan of Christine Lagarde and Jean Claude Juncker as well - indeed Draghi even explicitly mentions Juncker's 300 billion Euro insfrastructure plan in his August speech, so it would not completely surprise me to find that the ECB EU institutional purchases involved some related to the European Investment Bank and its financing of the project.

If you add to the Troika the "coalition of the willing" lead by Francois Hollande and Matteo Renzi (both of whom want some deficit relaxation) it isn't hard to see that it was Germany, and in particular the country's finance minister Wolfgang Schaüble, who was isolated, and basically cornered in the Finmin EuroGroup where Germany effectively have a veto (something they don't have on the board of the ECB, which is why much of the current "action" is centered on that institution).

So some sort of coherent policy is now being implemented in Europe in response to the regions long standing low growth issues. It's not clear that the measures being taken will serve to remedy the issues they were brought into being to address, but they will have long term consequences and they will make the currency union participants act more like one coherent whole, and in that sense they are to be welcomed. It may be that there is no real "solution" to the long term deflation issue, in which case other measures will eventually have to be found. But neither is having one weak country after another sliced off and savaged in the bond markets any more satisfactory as an outcome.

What we could be seeing is the birth of a transfer union with the specificity that there will be no actual inter-country transfers. If things are happening in this peculiar way then that will be because this is the EU, and this is how things are done here. It could be, of course, that the basic premiss that contemporary deflation has demographic roots is false. In that case none of this will happen, and put this post down to idle speculation, a mere fantasy world which never has and never will exist. But are you really sure enough that it is false to be willing to do that?


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

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