It is finally being recognized that the eurozone made a major policy breakthrough

by on December 16, 2011 at 10:06 am in Economics, Political Science | Permalink

Yields on short-term peripheral sovereign bonds are plunging, despite the fact that EU leaders appeared to make little progress at their highly-anticipated summit last week.

Pundits continue to expound on the flaws of the eurozone but markets are telling a different tale.

That’s because the European Central Bank may have already introduced roundabout measures that will solve some of Europe’s big problems—it’s making investing in peripheral sovereign debt a huge profit opportunity for banks.

Theoretically, financial institutions will be able coin money by borrowing ultra-cheap from the ECB and buying higher yielding sovereign debt.

Here is the story, and you will recall my earlier post here.  Karl Smith asks how this fits in with the treatment of collateral, and here is also a more skeptical take on the arbitrage.  My view is not that banks will find the arbitrage opportunity overwhelming (that is unclear), rather my view is that public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not.  Make no mistake about it, this is doubling down and raising the stakes.  It’s funding debt through more debt.  It’s wrong to say the summit accomplished nothing, or consisted merely of empty, unenforceable pledges of austerity, although it did that too.

At this point you have to be asking whether it is better to simply end the eurozone now, no matter how painful that may be.  Unless of course you are an optimist about Italy reaching two percent growth, or Germany becoming fully cosmopolitan.  As a politician I probably could not bring myself to pull the plug, but as a blogger I wonder if that might not, at this point, be the wiser thing to do.  Current crisis aside, does anyone out there see the euro’s governance structure — even with reforms — as even vaguely workable?

Addendum: Do note also that the ECB has made no strong promise to continue this program, and indeed it is not in a position to make a credible commitment, most of all on the quality of collateral issue.  That means a lot of ups and downs, shifting credibility, and the gains could well collapse quickly.

Ted Craig December 16, 2011 at 10:10 am

Question: If this works, will we have to admit the heroes weren’t the French or the Germans, but the Italians? Every Italian I’ve heard speak on the situation makes a lot of sense. They don’t seem as caught up in national or even continental pride.

Konstantin December 16, 2011 at 10:28 am

This is yet another can-kicking – a short-term effect, because banks are lacking collateral for using 3-year repo program, so they are buying gov-t bonds with the perspective of shoving them into ECB for 3 years. When 3-year auctions are done, crisis will return.
Also note that Italian yieds are still on highs.

Joseph Ward December 16, 2011 at 1:32 pm

3 years is a long time for growth to return to an economy.

Andrew December 16, 2011 at 3:46 pm

Growth can’t return when credit is being allocated towards a carry trade instead of business expansion

john haskell December 16, 2011 at 5:17 pm

thank you Andrew, at least someone noticed

Bill December 16, 2011 at 10:35 am

I always like monetarists because they never understand what money is: if you can “make” money by accepting weaker collateral, or if you can expand the money supply by letting banks take on more leverage, you have to wonder why some scream about “fiat currency” when there is alternative money around their feet.

By the way, how is gold doing.

Matthew December 16, 2011 at 10:59 am

Gold is up 10 years straight Bill. Ever since we tipped into negative real interest rates, with no end in sight.

Wanna bet on the price of gold on Dec 31 2012? I bet well north of $2000.

Don Brown December 16, 2011 at 3:53 pm

I’ll bet. What’s the wager?
I assume your “well-north” comment means you think there is a >50% chance of gold being above, say, $2000, on Jan 2 2013.

Matthew December 16, 2011 at 11:06 pm

I bet the price of gold will be above $2000 on January 2 2013. I’ll pledge one one of my gold Mexican Dos Pesos (currently around $75 worth of gold, selling for $90 or so on eBay) and you can pledge to obtain one on the open market in the event you lose (my assumption is that you don’t currently own any physical gold).

Send me your full name, address and contact info and we can formalize this wager via email:

m d cromer @ gmail.com

Rahul December 17, 2011 at 2:25 am

Well you must know something the markets don’t. Gold futures don’t seem to be so optimistic about gold prices right until 2014.

http://futures.tradingcharts.com/marketquotes/GC.html

Matthew December 18, 2011 at 7:46 pm

Yes, obviously I know something the markets don’t since I sold all my stocks in the summer of 2007 because it was beyond freaking obvious that the housing price collapse was going to destroy the banks and their share prices and precipitate a huge recession. And the banks were certain zeros until the government abolished real accounting in favor of mark to myth.

The combination of wall street bailouts (think AIG’s counterparties being given billions in free money from Treasury) and unprecedented and unceasing money printing since 2008 has kept the banks alive in a zombie state, and will eventually destroy the currency.

As for the futures market, considering that they literally STOLE the accounts and money of a plurality of the gold bulls who were playing in that arena (see MF Global) I am NOT AT ALL surprised that people inclined to go long gold are avoiding that cat-shat sandbox in favor of counterparty riskless alternatives — like holding coins and bars in your own personal possession.

I will give you another hint at the freaking obvious. The long term treasury market is the biggest bubble in the history of the planet, and people buying 10s and 30s here are going to be carried out in body bags in the next few years.

John Thacker December 16, 2011 at 12:19 pm

I don’t think you understand what monetarists are from your comment. Are you referring to Austrian economists? They’re different.

cthorm December 16, 2011 at 12:48 pm

About as different as night and day, especially on the topic of money. The only notable convergence of their ideas on money that I’m aware of is the market monetarist idea of NGDP targeting at a level that would average 0% or lower inflation.

Bill December 16, 2011 at 1:51 pm

John, I do, but perhaps you don’t.

Matthew December 16, 2011 at 2:14 pm

I guess that means — no you don’t want to take my bet on gold prices north of $2000 on January 1 2013. So the “by the way” comment about gold was just typical blather.

BTW, I added another 15% to my gold position last night — felt your bold snark was a perfect contrarian call for the end of the pullback. . .

Ted Craig December 16, 2011 at 2:30 pm

Bill, maybe you could explain your point better then, because I had the same thought as John.

Bill December 16, 2011 at 8:03 pm

Ted, As a bottom line proposition, money is a fiction. It is belief between two traders. Someone–whether J Pierpont Morgan in the early 1900s or the ECB altering its collateral requirement–in effect creates money by extending credit and someone else believing that you are good for it, either with your current wealth, or even your future wealth. This increases the money supply just as much as a new gold discovery, or some act of the FRB. Some here seem to think that it is the government that creates money, when in fact, money is created the same way it always was: by two traders exchanging cylinder seals in the desert for some spices, believing the cylinder seals meant something. I can’t find my copy of Kindleberger’s Manias and Panics but he has a great discussion of the Austrian school and monetarists and financial and other panics. It’s more in your head than in a balance sheet. Read Kindleberger. He got his Nobel for a reason.

Bill December 16, 2011 at 9:53 pm

Ted Craig and John Thacker,

Here are some text materials from Kindleberger’s Marshall Lectures that explain this better than I did using google books (search: kindleberger and austrian school):

http://books.google.com/books?id=I5Y5AAAAIAAJ&pg=PA69&lpg=PA69&dq=kindleberger+and+austrian+school&source=bl&ots=xYPOWhC2dl&sig=HIfpKk64Rxt36yoVCsoxSM4DsCs&hl=en&sa=X&ei=mgPsTrjXIoWRiALZtri5DQ&sqi=2&ved=0CCAQ6AEwAQ#v=onepage&q&f=false

Ted Craig December 17, 2011 at 7:01 am

Kindleberger has a Noble? Or are you referring to Marshall’s?

Rahul December 16, 2011 at 10:36 am

How can Tyler not like neither rising nor falling soverign bond yields? The markets right when I agree with its judgement and not otherwise?

ricardo December 16, 2011 at 11:14 am

He can not like rising yields because they are indicative of underlying structural problems (re solvency). He can not like falling yields for a different reason, namely that the structural problems are being ignored.

msgkings December 16, 2011 at 3:18 pm

Soooo, he only likes yields that don’t change?

Benoit Maison December 16, 2011 at 10:44 am

Funding debt with more debt? Tssk, have you not read that not all debt is created equal? By a Nobel prize recipient, no less: http://krugman.blogs.nytimes.com/2011/11/25/death-by-hawkery/

T. Shaw December 16, 2011 at 11:16 am

Misallocation of ECB assets/credit will not solve excessive PIIGS default/repayment risk. When ECB stops injecting massive liquidity, the markets will tell a far different tale.

There is no economics purpose here but this is a chimera executed to postpone inevitable sovereign debt defaults and recession.

It will it not cure euro zone’s problems (PIIGS sovereign debt defaults; structural crises of the Eurozone; potential massive bank failures in Europe and U.S.).

Que sera sera. Italy survived the Goths, the Normans, the Arabs, the HRE, the Spanish, the French, the Nazis, the Americans, etc. For sure, Italy will survive. Owners of Italian debt will be less sanguine.

affenkopf December 16, 2011 at 12:15 pm

There was no Italy in the time of the Goths, Normans or Arabs.

Richard Besserer December 16, 2011 at 2:50 pm

Of course there was. Italia was what the Romans called the peninsula they lived on, and their region Latium (now Lazio), hence Latins.

Matthew December 16, 2011 at 2:17 pm

“When ECB stops injecting massive liquidity, the markets will tell a far different tale.”

There will be no end to the continuous and massive injections of liquidity everywhere, in every banking system, until the last trillion dollar and euro note can’t buy a grain of rice. No exit.

T. Shaw December 16, 2011 at 3:21 pm

Right. Plan and act accordingly.

At lunch, I toddled up Fifth Avenue and traded a fistful of worthless paper for a Canadian (gold bullion) Maple Leaf and added it to the collection.

NAME REDACTED December 16, 2011 at 11:20 am

“It’s funding debt through more debt. ”

Hold on to your butts… prepare to see the next crash be an even larger one.

JP Koning December 16, 2011 at 11:27 am

I don’t think the key here is arbitrage and government monetary financing. It’s about a slow bank run that has been enveloping Southern Europe for a few years now. The mechanism which governs intra-Euro payments requires Greek/Italian etc banks to “solve” for the bank run by submitting collateral to their national central bank in return for settlement balances. Much of this is done overnight or on a weekly basis. By establishing 3 year operations, the ECB is telling the banks and the rest of the world that they will continue to meet the demands of anyone running on the Southern European banks for the next 3 years. That sort of commitment to the system might be large enough to stop the bank run.

It’s similiar to how, in the old days, banks suffering bank runs would often bring out all their cash and gold from the vaults and put it on display behind the bank teller so that depositors, seeing the actual backing assets, would turn away. The ECB is putting its cash on display.

prior_approval December 16, 2011 at 11:38 am

Wait – eurogeddon is still coming?

Repent now.

Or recognize, as I think it is fair to say every single European above the age of reason does, that currencies come and go (just like a decade ago, more or less).

And oddly, the EU is still muddling through – continuing a roughly 54 year streak of doing just that, while everyone around it predicts doom.

Which will occur, in due course. Just ask Comecom how that worked out. OK, that was maybe not a good example – Comecom dissolving turned out to be a major plus for Eastern Europe, and basically, not a single shot was fired as it disappeared from the historical stage.

Fascinating story, and the major reason why East Germans in particular remain so thoroughly skeptical about the EU – http://en.wikipedia.org/wiki/Comecon

Samuel X Brase December 16, 2011 at 11:46 am

I’m not an expert, but: won’t this plan blow through the German-mandated debt-to-GDP limits? Which have already been blown through by something like 14/17 eurozone countries. Won’t this just lock governments into austerity for longer? Borrow to pay off the old debts…forever.

TallDave December 16, 2011 at 11:59 am

Some technical solution like this to preserve the status quo was always the most likely short-term outcome.

Now that they’re allowed to essentially print euros thirdhand, the periphery can abandon the pretense of austerity — indeed, I expect their voters will demand it. This will stabilize the short-term but we’ll see how the German electorate responds over the next few years.

NAME REDACTED December 16, 2011 at 12:14 pm

Bond yields are meaningless as the ECB is buying the bonds.

cthorm December 16, 2011 at 12:51 pm

The ECB bond buying activity is not that active. They’re effectively putting a cap on the yields of some sovereigns, most notably Italy at 7%. You could argue they are buying indirectly through large banks via the new collateral rules, but that’s exactly what the article is saying.

Rahul December 16, 2011 at 12:52 pm

Is ECB buying or are the banks buying?

NAME REDACTED December 16, 2011 at 1:32 pm

“Is ECB buying or are the banks buying?”

Its same thing.
1) If the ECB is paying banks to buy the bonds, the bond rates are no longer indicative of the risk.

2) Say that the risk says the rates should be at 7% when the banks are paying depositors 3%. This means that the risks signify a 4 percentage point spread. But the banks can now borrow at a lower rate from the ECB so the Countries’ rates drop. This doesn’t mean that the risks have changed, only that its cheaper for the countries to borrow.

3) Really what is happening is that the ECB is buying the bonds through other banks. Because the ECB is lending the banks money to buy those bonds, the risk falls ultimately on the ECB.

Rahul December 16, 2011 at 1:59 pm

Does the ECB money come with the requirement that banks must buy sovereign bonds? Why won’t the yields still reflect the risk? Or is the argument that the banks have nothing else left that they can invest in?

NAME REDACTED December 17, 2011 at 12:06 pm

“Does the ECB money come with the requirement that banks must buy sovereign bonds?”

Most countries require their banks to hold a certain percent of their holdings as local-country government bonds. Also, local-country government bonds require zero collateral regardless the risk.

Richard Besserer December 16, 2011 at 12:16 pm

Telling the EZ to go back to their old currencies to solve the banking crisis is a bit like telling the 50 US states to start issuing their own bucks, as if anyone would accept them. The euro, as such, isn’t the problem.

The problem is that Europe’s banks are insolvent. They lent far too much money to corrupt, incompetent governments who spent the money on themselves and their supporters (Greece, Italy) and spendthrift consumers who spent the money on houses they didn’t need and couldn’t really afford (Ireland, Spain). That would have been their undoing in any monetary system.

Now it’s become clear that the banks have no realistic chance of getting repaid, they’re trying to blackmail the EU into acting as their collection agency. Make Europe’s taxpayers cough up our money, they say in effect, or their life savings disappear in a single night—oh, and the paycheques of your soldiers and policemen will start to bounce. Good luck outrunning the lynch mob. You’ll find us in the capital of an emerging market, having moved our personal assets offshore long ago, dividing our retirements between enjoying a new trophy wife sourced from the emerging market, and watching coverage of Europe’s new generation of dictatorships and wars on Russia Today or CCTV.

Until Europe’s governments call their bluff, this’ll never be over.

Steven Kopits December 16, 2011 at 1:06 pm

To have countries exit the Euro zone is nothing like having the 50 states issue their own currencies. Each of the Euro countries is sovereign politically and distinct culturally.

Richard Besserer December 16, 2011 at 2:15 pm

Have you visited the States much? Their cultural, political and economic variation is only seriously rivalled by the EU. California is nothing like Ohio is nothing like Georgia is nothing like New York. The States’ advantages include a common language (English) which results in labour mobility the framers of Schengen could only dream of, and a truly unified banking system where—imagine!—insolvent banks are allowed to fail in an orderly fashion.

If Irish bank AIB had not been an Irish bank but a Florida bank, once there was no more room for doubt it was insolvent AIB would have been raided by the FDIC without warning one evening, and would have re-opened the next morning as branch offices of Barclays or SocGen or Deutsche Bank (or whomever the FDIC picked to take over AIB). The depositors would have been covered up to a reasonable maximum, AIB’s assets would have been liquidated, and the equity holders would have been wiped out.

Meanwhile AIB’s management would have been purged and sent to the dole queue where they belonged, and would be expected to be grateful they didn’t go to jail for fiddling their depositors out of their savings. And that would have been that.

In the States, merely illiquid banks can count on the Fed’s support, much more than illiquid banks have been able to in the euro zone. What Washington does not do is simply assume the debt of insolvent state governments, or waste time letting clearly insolvent banks go out of business.

Matthew December 16, 2011 at 2:30 pm

“and a truly unified banking system where—imagine!—insolvent banks are allowed to fail in an orderly fashion. ”

I laughed so hard on reading this I think I snapped a rib. . .

Richard Besserer December 16, 2011 at 2:48 pm

Okay, you got me there. I’ll add the qualifier. Smaller, regional banks are allowed to fail, because they’re no big deal. By US standards, no Irish bank, concentrated as their portfolio and business line was in a small part of the EU, would have worth bothering to save in its original form.

I admit the story for the likes of Citi and BoA (and Commerzbank and SocGen) is a lot more complicated than this. The bigger and more systemically important a bank gets, the harder an orderly failure gets. AIB and Anglo Irish were doable. Ireland’s bank balance sheets were only huge compared to Ireland’s economy. Compared to the EU’s economy they were chicken feed. A European Deposit Insurance Corporation could have organized their closure fairly easily.

Ted Craig December 16, 2011 at 2:34 pm

That first statement is utter nonsense.

Cliff December 16, 2011 at 5:23 pm

+1

Bill December 16, 2011 at 1:56 pm

Richard, The Irish and Spanish banks lent money to the real estate industry, as did Commerzbank. The problem is that government have backstopped overleveraged banks, which makes their finances shakier. Both Ireland and Spain were running surpluses before the real estate crisis. You can also look at Iceland.

You have to look at the source of the problem (overleveraged banks stuck in a real estate hole), not at the person who is trying to protect the banks from financial collapse.

Richard Besserer December 16, 2011 at 2:37 pm

That’s precisely my point. Ireland’s fundamentals were fine before the banking crisis. Ireland only has a debt problem now because it assumed the debt of its insolvent banks. Basically the banks gave Brian Lenihan an ultimatum—assume our debt or every bank in Ireland closes and takes the life savings of the Irish people with it. Gerry Adams gets to be the next Taoiseach and by the time the next Dail meets you’d better be in London, Brian, because you won’t like what the Shinners have in store for you. If you make it there in one piece and find yourself in a pub near the City, don’t count on us buying you a drink.

In the States, no bank could have ever blackmailed a state government like that. Organizing orderly defaults of banks is a federal responsibility, not a state one.

john haskell December 16, 2011 at 5:19 pm

if California were to issue scrip and announce that it would be accepted in payment of state taxes, and the Federal Government didn’t prohibit them from doing so, it would be immediately accepted throughout the state of California.

kaganovich December 16, 2011 at 12:25 pm

so this is masked printing of money. what’s in it for the failed economies? isn’t devaluation in their own currency still better? what’s the chance of high inflation down the road making the germans mad, or like scott sumner keeps saying, is it a good thing that massive amounts of money are to be printed because it’s been contracting so heavily.

Matthew December 16, 2011 at 2:34 pm

What’s in it for everyone is that .the banking system can continue to exist another day (at the gradual, then faster and faster expense of the integrity of the currency).

BTW the Fed hasn’t remotely stopped money printing with the supposed “end” of QE2 either. Nor will they, ever. They just don’t talk about it anymore (much like the tens of trillions in secret loans and guarantees they spread around to all their zombie commercials since 2008).

Steven Kopits December 16, 2011 at 1:21 pm

Meanwhile, the NYT reports that in Hungary Prime Minister Orban is busy trying to pack the monetay policy council, the committee which sets monetary policy in Hungary. This sort of thing has been tried before, but I would think it will succeed this time. It is a great opportunity to screw up monetary policy. Thus, darkness continues to descend on Hungary, with the EU impotent and uninvolved.

Why do we pretend we lack the tools–simple and easy to implement–to deal with this sort of thing? Are economists entirely incapable of simple root cause analysis? Do they really understand nothing of principal-agent theory?

The Anti-Gnostic December 16, 2011 at 3:10 pm

You mean to tell me the president of a country is packing the executive branch with his cronies? What barbarians! We need to invade them.

Richard December 16, 2011 at 1:55 pm

Richard Besserer makes a good point that is too often ignored. There are two distinct questions here. The first is whether a country defaults on its sovereign, Euro-denominated debt. The second is whether the Euro continues to be that country’s legal tender. At least in theory, these question are completely separate. Yet everybody keeps conflating them. Why?

By way of analogy, California could default on its debt but nobody would say that therefore it must start printing its own currency. It would just do what any other bankrupt debtor does: have its old debt written down and start over again. The legal tender in California could and would still be dollars. (Don’t answer this by saying that California is prohibited from printing its own currency. That objection misses the point, which is that there is no economic law whereby a sovereign debt default requires that sovereign’s citizens to change currencies.)

I’ve asked this question of many people but nobody seems able to provide a coherent answer: Why does a sovereign debt default by one or more Eurozone countries necessarily entail a change in the legal tender in those countries?

Mogden December 16, 2011 at 3:24 pm

I believe it is driven by the need to print enormous amounts of money to sustain government deficits after the default (when borrowing becomes much more difficult due to interest rate increases.) If they could print that money in Euros, it would be all right, but others would probably tell them not to.

msgkings December 16, 2011 at 3:28 pm

I think it references the why…if you are going to take the hit of defaulting on your debt, you might as well at least get the benefit of a new, weaker currency.

It’s better overall to default by declaring you’ll pay back your debts in full…in drachma.

If you can prevent the massive bank run as everyone who hasn’t already done so gets as many of their Euros out of the country as they can before they get converted.

john haskell December 16, 2011 at 5:22 pm

also you can’t close the budget deficit while you are stuck in the euro, as your cost base is still uncompetitive, and any savings you generate in the economy would just be siphoned out, since your banks just failed (remember you just defaulted on your gov’t debt) and everyone would deposit their savings elsewhere (ie Germany).

Crenellations December 16, 2011 at 2:06 pm

The FT had an article about rogue traders (the ones who lost billions and crushed investment houses) a few weekends ago. Their psychological defect was gamblers fallacy: if I just keep doubling my bet, I’ll get back to even. I guess no one at the ECB read that.

Thomas December 16, 2011 at 4:11 pm

From today’s WSJ: Banks, insurance companies and pension funds in Northern Europe have slashed their lending to overextended countries to safeguard their money. Many now are comfortable investing only at home or in the safest markets such as Germany.

guanxi December 17, 2011 at 4:03 pm

“At this point you have to be asking whether it is better to simply end the eurozone now, no matter how painful that may be.”

Maybe from an economic perspective (I don’t know), but the Eurozone has great political value, maintaining long-term peace, stability, and prosperity in Europe, as well as potentially giving our allies more weight in the world (as part of a 300 million person state rather than many smaller nations).

It’s certainly worth the cost. Imagine, and remember, the political alternative.

Rahul December 17, 2011 at 9:55 pm

But how much of those benefits need a common currency? Couldn’t we retain freedom of movement, goods, and many of the other goodies but just do away with the Euro?

guanxi December 18, 2011 at 10:08 pm

“But how much of those benefits need a common currency? Couldn’t we retain freedom of movement, goods, and many of the other goodies but just do away with the Euro?”

Think of it this way: HOw would the introduction of currencies and central banks unique to each state affect the U.S.?

Barkley Rosser December 18, 2011 at 4:33 pm

Tyler,

Why is it so crucial that Italy achieve 2% growth rate? Sure, would be nice, but for only about the umpteenth time here, let me remind everybody that Italy is one of the four only countries in the eurozone that is running a primary surplus. The only reason it has a deficit problem is that it has been having to pay very high interest rates due to the fear that it will default due to very high interest rates. As those come down, the “deficit problem” disappears, even with flat growth. This really should be kept in mind. Please stop repeating media nonsense, Tyler.

TallDave December 18, 2011 at 8:57 pm

Demographics and the long-term GDP trend.

Michel Phillips December 19, 2011 at 6:01 pm

Maybe I’m just cynical and simplistic, but isn’t the only thing that appears to CERTAIN about this plan is that the banks make a large profit.

Why does that always seem to be the highest priority?

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