Over 6 weeks ago we distributed the attached Eurosystem Solutions paper.
It described the unique non-standard measures being used for by the Eurosystem and ECB to address bank solvency and national solvency issues and the movement towards a real solution involving the ECB.
Now the ECB has announced what is very close to the real solution: unlimited bond purchases.
Regardless of conditionality, or even in spite of conditionality, this is the crossing of the line into the notion that there is an entity that can credit accounts in Euro in unlimited amounts.
While conditionality is the apparent necessary circumstance, and it’s likely national authorities will play along, these ECB purchases will have to take place regardless of conditionality. If Spain says they can’t comply, is the ECB going to let them default? The ECB has done all this to avoid Spanish default.
The best case is for the markets to recognize the ECB backstop and so regular purchases aren’t very necessary. There will be lots of movement towards coordination of budgets and banking supervision.
But the ECB line has been crossed.
Sixteen years after our AVM/III July 1996 Bretton Woods conference that identified the severe credit problems with the looming Maastrict rules (1/1/99), and eleven years after Warren’s famous paper on the potential European credit crisis “The Rites of Passage” we are finally seeing the necessary repair to the EMU.
There still remain political obstacles, court challenges and the like, but the imperatives to avoid a complete collapse of the Euro financial system have driven virtually all the important constituents to this necessary path of solution.
Category Archives: Banking
Gold standard thoughts
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> (email exchange)
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> On Fri, Aug 24, 2012 at 5:28 AM, Dave wrote:
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> When you get a chance could you send a quick note out on problems with this type of
> thinking?
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The reasons nations have gone off the gold standard isn’t because it was working so well and their economies were doing well. The reason they go off, like the US did in 1934, was because it was a disaster.
Historically nations suspend their gold standards in times of war, when they need their economies to function to the max. If a gold standard was so good for an economy, why suspend it when you need max economic performance? Obviously because it is not conducive of maximum real output.
The ideological issue is whether the primary function of the currency is to be an investment/savings vehicle, or a tool for provisioning government and optimizing real economic performance. In a market economy you can’t fix the price of two things without a relative value shift causing you to be buying one of them and running out of the other. Likewise, you can’t sustain full employment and a stable gold price if there is a shift in relative value between the two.
A gold standard is a fixed exchange rate policy, where the govt continuously offers to buy or sell gold at a fixed price.
This means the holder of a dollar, for example, has the option of ‘cashing it in’ for a fixed amount of gold from the govt, and a holder of gold has the option of selling it at a fixed price to the govt.
Therefore a new gold discovery which causes gold to be sold to the govt is inflationary and tends to increase output and employment, and a gold ship sinking in transit or a sudden desire to hoard gold is deflationary and tends to decrease output and employment. And there’s nothing that can be done about these relative value shifts, except to ride them out. The only public purpose served (by definition) is the stable nominal price of gold set by Congress.
With a gold standard, like any fixed fx regime, interest rates are necessarily set by market forces. With the govt’s spending being convertible currency, it is limited to spending only to the extent it has sufficient gold reserves backing the currency it spends. With gold reserves generally pretty much constant and not expandable in the short run, this means govt spending is limited to what it can tax and/or borrow. So when the govt wants to deficit spend, doing so by ‘printing’ new convertible dollars risks those dollars being ‘cashed in’ for gold. Govt borrowing, therefore, functions to remove that risk by delaying conversion privileges until the borrowings mature. This means the govt is competing with the right to convert when the govt borrows. In other words, the holder of the gold certificates has the option of either converting to gold or buying the treasury securities. The interest rate the treasury must pay therefore represents the indifference rate of holders of the convertible currency between cashing in the currency for gold now or earning the interest rate and not being able to convert until maturity. Note that it’s in fixed exchange rate environments that govt borrowing costs have soared to triple digits as govts have competed with their conversion features, and that govts generally lose those fights as the curve goes vertical expressing the fact that at that point there is no interest rate that can keep holders of the currency from wanting to convert.
Note that this also means the nations gold reserves are the net financial equity that supports the entire dollar credit structure, a source of continuous financial fragility and instability.
It’s all here in a paper I did in the late 1990’s.
Hope this helps!
A few more thoughts:
Being on the gold standard doesn’t prevent a financial crisis, but it makes the consequences far more severe.
We were on a gold standard when the roaring 20’s private sector debt boom lead to the crash of 1929 and the depression that followed. 4,000 banks closed before we went off gold in 1934, and it was only getting worse which is why we went off of it.
Gold would not have prevented the pre 2008 sub-prime boom, but it would have made the consequences far more severe. Including no Fed liquidity provision to offset a system wide shortage due to hoarding and banks bidding ever higher for funds that didn’t exist, most all firms losing inventory financing and being forced to liquidate inventories as rates spiked competing for funds that didn’t exist, and no deficit spending for unemployment comp as federal revenues fell from the collapse. In other words, the automatic fiscal stabilizers we rely on can’t be there. Instead it’s a deflationary disaster that only ends when prices fall sufficiently to reflect changes in relative value between gold and everything else.
Note that the recent decade of gold going from under $600 to over $1,600 is viewed as a sign ‘inflationary’ and a 250% ‘dollar devaluation’ as it takes 2.5x as many dollars to buy the same amount of gold. But if we were on a gold standard, and all else equal, and gold had been fixed at $600 back then, the same relative value shift would be manifested as the general price level falling that much in an unthinkable deflationary nightmare.
Asmussen statement
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> (email exchange)
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> On Wed, Aug 22, 2012 at 3:02 AM, wrote:
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> You are totally right about him, I sent you a word doc with his exact words
> (emphasis mine)
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Repeat: Asmussen: ECB Wants To Eliminate Doubts About Euro
2012-08-20 05:36:05.371 GMT
–First Ran On Mainwire At 2257 GMT/1857 ET Sunday
FRANKFURT (MNI) – The European Central Bank wants to remove any doubt about the permanence of the common currency, ECB Executive Board member Joerg Asmussen said in a newspaper interview published in Monday’s edition of the German daily Frankfurter Rundschau.
The German board member told the paper that financial market certainty regarding the continued existence of the euro was a necessary condition for the currency’s stability.
The ECB’s planned new bond-buying program is superior to its predecessor, the Securities Market Program, and the Governing Council will work on details at its next meeting, Asmussen said.
Noting the high risk premia for some sovereign bonds in the euro area, which he said were in part due to concerns about the reversibility of the euro, Asmussen said that such an exchange rate risk was theoretically not admissible in a currency union and was leading to the incomplete transmission of ECB monetary policy to some euro area economies.
“Our measures attempt to repair this defect in the monetary policy transmission mechanism,” he said. The worries about the euro’s permanence are no wonder, he added, given “how carelessly” the currency is talked about in Europe.
“It is precisely these concerns about the continued existence of the euro that we want to rid market participants of,” he said.
Asmussen asserted that the ECB is acting within its mandate, adding that “a currency can only be stable if there is no doubt about its existence.”
The new bond-buying program meant to address this issue “will be better conceived” than the SMP, he said, repeating that the ECB will only act in tandem with the EFSF or ESM and that interested countries must submit a request and satisfy “comprehensive economic policy conditions.”
The ECB’s Governing Council “will decide in complete independence whether, when and how bonds are purchased on the secondary market,” he added.
What happened last summer with Italy, which failed to use the time bought by ECB bond purchases to make necessary adjustments, cannot be allowed to happen again, he said.
Moreover, in the new program the ECB will deal with the problem of senior status, which interferes with affected countries’ return to capital markets because private investors fear being disadvantaged vis-a-vis the ECB, he said.
Asked if the new program could be successful because it will be unlimited in time and scope, Asmussen confirmed that ECB President Mario Draghi had said as much.
“But wait and see,” he said. “We are working on the design of the new program and will occupy ourselves with these questions in our next meeting.”
Credit and money growth in the euro area are “moderate,” and “inflation expectations in the entire Eurozone are firmly anchored to our target,” he said. “We are monitoring price developments very closely and have all the necessary instruments to fight possible inflationary dangers effectively and in a timely manner.”
ECB August Meeting
Not to forget this is the just the beginning of ‘doing what it takes’ to sustain the euro, and make it ‘safe’ for investors.
That’s all inclusive, though not necessarily immediate.
And ‘anchoring’ the short end ‘automatically’ goes a very long way towards anchoring the long end with regard to risk premium.
Karim writes:
Draghi announced significant philosophical changes today. The key announcements were:
- The ECB was ready to renounce seniority on its bond purchases.
- The size of future purchases was open-ended: ‘size adequate to reach its objectives’.
- Future purchases may not be sterilized, as they have been with the SMP so far.
- Purchases would be front-end focused as that ‘falls squarely in line with monetary policy instruments’. A key instrument is obviously the LTROs. So would imagine purchases would be 3yrs and in on the curve.
The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions [for some action on the ECB side]. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed.
Other news was that:
- As in the excerpt above, purchases would be subject to strict conditionality via the EFSF (i.e., Spain has to accept a Memorandum of Understanding). Fiscal consolidation and structural reform were listed as the key conditions.
- He threw cold water on the ESM getting a banking license, saying he was ‘surprised by the attention this has received’.
- Logistics and objectives on bond purchases were TBD by a committee.
- Further non-standard measures were forthcoming.
- Rate cuts were discussed but unanimously voted down; as for a negative depo rate he said ‘we are in unchartered waters’, implying the hurdle may be high.
Relative to levels before Draghi’s London speech last week, Spanish 2y yields are 200bps lower, and 10yr yields are 50bps lower.
ECB notes?
An interesting move by the ECB would be to offer short to medium term notes in the market place.
As discussed over the years, unlike other currencies, the euro has no ‘risk free deposits’ available to anyone other than member banks and foreign governments.
This has probably caused substantial numbers of investors to sell their euro for other currencies rather than hold any of the available euro denominated financial assets.
If so, ECB notes could mark the return of these portfolio to ‘normal’ allocations to euro denominated financial assets, which would offer strong support for the euro vs other currencies.
And with the ECB measuring success by the strength of the euro, this could be an attractive proposition.
It would attract euro deposits from the banking system, which the ECB can easily accommodate by continuing its current policy of liquidity provision for its member banks as needed.
Additionally, and not that it actually matters for inflation, lending, aggregate demand, etc., most monetarists would not include these notes as part of the ‘money supply’ but instead as an anti inflationary ‘sterilization’ measure.
ECB’S NOWOTNY SEES ARGUMENTS FOR GIVING ESM A BANKING LICENSE
Yes, I think it’s all still happening as suggested last month after Trichet proposed a plan that included the ECB.
Lots of market vol, doubts, fears, etc. and all for good reason as it could fall apart as easily as it could all succeed. I still lean towards the latter.
From Dave Vealy:
NOWOTNY SAYS ESM GAINING BANKING LICENSE IS ONGOING DISCUSSION
NOWOTNY NOT AWARE OF `SPECIFIC DISCUSSIONS’ WITHIN ECB ON ESM
ECB’S NOWOTNY SEES ARGUMENTS FOR GIVING ESM A BANKING LICENSE
From what I am aware, first time an ECB official raises this issue. A significant positive surprise if this is the case, as it would signficantly increase the ESM’s capacity for intervention.
ECB’S NOWOTNY SEES ARGUMENTS FOR GIVING ESM A BANKING LICENSE
ECB’S NOWOTNY COMMENTS IN INTERVIEW WITH BLOOMBERG
NOWOTNY SAYS EURO-AREA ECONOMIC DIVERGENCES ARE INCREASING
NOWOTNY SAYS INFLATION WILL SLOW, ECB DOESN’T SEE DEFLATION
NOWOTNY URGES AGAINST RUSHING ECB BANK SUPERVISORY ROLE
NOWOTNY: ECB NOT TALKING ABOUT NEGATIVE DEPOSIT RATE FOR NOW
NOWOTNY SAYS ESM GAINING BANKING LICENSE IS ONGOING DISCUSSION
NOWOTNY NOT AWARE OF `SPECIFIC DISCUSSIONS’ WITHIN ECB ON ESM
John’s got it!
Congress, Not the Fed, Needs to ‘Get to Work’
By John Carney
July 17 (CNBC) — The Senate Banking Committee’s grilling of Federal Reserve Chairman Ben Bernanke just got weird.
Senator Charles Schumer, the New York Democrat, proposed a novel theory of political management of the economy shortly before 11 am Tuesday morning.
The gist of the theory: If the elected branches of government cannot agree to act, the responsibility for the economy falls to the Fed.
Schumer’s argument amounted to the idea that that because disagreements between Republican and Democrats (and, of course, the political ambitions of members of both parties in a presidential election year) are blocking any agreement to provide fiscal relief to the economy, the Fed should “get to work.”
It’s tempting to say that this is the drunk’s theory of the bar tab.
The drunk has been drinking so much he can’t work—and therefore can’t afford to pay his tab. So it’s up to the bartender to pour another cocktail and extend the tab a bit longer.
But this would be insulting to drunks everywhere. The drunk actually understands the economics of the bar better than Schumer understands the difference between monetary and fiscal policy.
The economy right now suffers because the private sector is attempting to save more than it spends, mostly by paying down its enormous debt burden. Because everyone’s income comes from someone else’s spending, reduced overall spending results in income reduction. In our economy, that means higher unemployment.
If the economy is going to grow while households and businesses pay down their debts instead of spending, someone else must take the opposite side of the trade by growing spending more than its income.
With the rest of the world heading toward recession, the only plausible source of this added income is the government. In other words, the government must cut taxes relative to spending (or grow spending relative to taxes) to replace the lost income in the private sector.
What the economy certainly isn’t suffering from right now is a shortage of liquidity or a meager money supply. Which is to say, we’ve reached the limits of what the Fed can do to spur growth. (Although perhaps not the limits of what the Fed can do to fend off a sharp turn downward in the economy.)
To hear a member of the shirker branch of our government blame the Fed for not doing enough would be laughable if we weren’t living with the consequences of the shirking.
Sen. Schumer—and his fellow lawmakers—are the ones who should “get to work.”
Spanish Banks’ Net ECB Loans Leap to Record 337 Billion Euros
Seems to me if there was going to be a liquidity problem with the banks the ECB would have already let it happen:
Spanish Banks’ Net ECB Loans Leap to Record 337 Billion Euros
By Emma Ross-Thomas
July 13 (Bloomberg) — Spanish lenders’ net borrowings from the European Central Bank jumped to a record 337 billion euros ($411 billion) in June. Net average ECB borrowings climbed from 288 billion euros in May, the Bank of Spain said. Gross borrowing was 365 billion euros, up from 325 billion euros in May, and accounting for 30 percent of gross borrowing in the whole euro region. Spain saw the biggest outflow of foreign investment in April since the start of the euro, Bank of Spain data show. Non- residents cut their holdings of Spanish bonds to 37.5 percent of the total in May, from 51.5 percent at the end of last year. Spanish banks picked up the slack in the first quarter, before starting to reduce their holdings in April, according to Treasury data.
Banks Face $6 Billion of Libor Litigation, Morgan Stanley estimates
The libor scandal is particularly bad, even though not a lot of actual $ gains/losses involved, in that it happened after the financial crisis when there was at least some hope that the surviving major banks had, in general, cleaned up their act. And also at least some hope that the crisis was a wake up call to bank regulators and supervisors.
It’s not that hard to spot. For example, relatively wide libor basis swaps indicate markets are discounting libor settings being away from actual deposit rates by more than typical bid/offered spreads.
Banks Face $6 Billion of Libor Litigation, Morgan Stanley estimates
July 12 (Bloomberg) — Banks being probed for attempting to rig benchmark interest rates could face $6 billion of related litigation costs, analysts at Morgan Stanley estimated. The 16 banks may also lose 4 percent to 13 percent in 2012 earnings per share from regulatory fines on a base case scenario, Morgan Stanley analysts led by Betsy Graseck wrote in a note to investors today. They may also suffer from tighter scrutiny from regulators in response to the Libor investigations, the analysts said.
ECB to Ensure That Lenders Have Enough Liquidity, Visco Says
More constructive hints?
ECB to Ensure That Lenders Have Enough Liquidity, Visco Says
(Bloomberg) The European Central Bank will continue to guarantee sufficient liquidity for lenders and keep up the fight against market fragmentation among the 17 countries that share the euro, Bank of Italy Governor Ignazio Visco said. “The ECB can’t but continue to pursue these objectives,” Visco said today in a speech in Rome. The ECB cut rates to a record low on July 5 on concern the euro area is slipping deeper into a recession. The central bank, headed by Mario Draghi, agreed in June to help nations in distress by acting as a buying agent for sovereign bonds purchased by government-run bailout funds. The rate cut, to 0.75 percent, is an indication of the ECB’s intention to guarantee “adequate monetary conditions” in the euro area, Visco said. “It followed other measures adopted last month designed to continue to ensure necessary liquidity for the banking system and fight the effects of the fragmentation of monetary and financial markets,” he said.
German Finance Minister Asks Court Not to Block Euro Assistance
(New York Times) The German finance minister warned on Tuesday that there would be severe consequences for the euro currency union if this country’s highest court blocks Germany’s recent ratification of two measures for fighting Europe’s financial crisis.
Officials Spar Over Who Will Guarantee Bank Losses
(WSJ) German finance minister Wolfgang Schäuble said that even once the euro zone’s bailout fund has been authorized to directly recapitalize struggling banks, the lenders’ host government should retain final liability for any losses. “We expect that the final liability of the state will remain” even once the banking supervisor is up and running, he told journalists. He added that what mattered was that the bank support wouldn’t add to a country’s debt—something that he said would be possible even under a scenario where the government retained liability for potential losses. Other officials insisted that banks’ host states wouldn’t have to guarantee any support from the bailout fund.
A Euro-Zone Strategy Shift
(WSJ) Finance ministers from the euro zone agreed that Spain need only reduce its deficit to 4.5% of gross domestic product next year, and 2.8% in 2014, in order to avoid financial penalties. The deal, Spanish Finance Minister Luis de Guindos told reporters, had been clinched without fresh demands on fiscal policy from euro-zone partners, although Eurogroup Chairman Jean-Claude Juncker had warned that there would be a thorough examination of every bank that asks for aid. “I repeat it again, and these are fundamental points, these are two completely independent agreements, they are not related in any way because there is no macroeconomic conditionality in the agreement on the memorandum [of understanding],” he said.
Noyer Warns Hollande of France’s ‘Serious’ Economic Weakness
(Bloomberg) France’s unit cost of labor of 34.20 euros an hour compares with Germany’s 30.10 euros, Italy’s 26.80 euros and 20.60 euros for Spain. Unit labor costs in France have increased by about 20 percent relative to Germany since 2000 as French companies implemented the nation’s 35-hour work-week law, according to Coe-Rexecode. “Of all advanced countries, France has registered, since 2000, the sharpest decline in its market share in global exports,” Bank of France Governor Christian Noyer said. “The drop in the number of hours worked and rigidities in working time arrangements have probably played a role” and reviving exports means tackling all sorts of restrictions that hamper activity, he said.
French current account deficit narrows in May
(AFP) The French current account deficit narrowed slightly in May, owing to a smaller shortfall in the trade of goods and a bigger surplus in services, official data showed on Monday. The Bank of France said the current account, which measures all current payments in and out of the country, showed an overall deficit of 4.1 billion euros ($5.3 billion), compared with a 4.4 billion euro shortfall in April. A breakdown of data showed that the deficit in exchanges of goods had decreased to 5.6 billion euros in May from 6.0 billion in April, while a surplus in services grew to 1.9 billion euros from 1.7 billion.
This is not good if/when implemented:
Rajoy Announces 65 Billion Euros in Budget Cuts to Fight Crisis
(Bloomberg) Spanish Prime Minister Mariano Rajoy announced tax increases and spending cuts totaling 65 billion euros in the next two-and-a-half years. Rajoy’s fourth austerity package in seven months will raise the sales levy to 21 percent from 18 percent; scrap a tax rebate for home buyers; scale back unemployment benefits; consolidate local governments and eliminate the year-end bonus for some public workers. The budget cuts are about double those previously announced. Spain’s central government budget deficit swelled to 3.41 percent of gross domestic product in the first five months of the year, approaching the full-year goal of 3.5 percent after the government brought forward transfers to regional administrations and the social-security system.
Spain Agrees to Guarantee Bond Issuance of Cash-Strapped Regions
(Bloomberg) Spain will guarantee bonds issued by regional governments to help them regain access to capital markets and ease a funding squeeze. The program will be “voluntary” for regions and will come with additional conditions on budget deficits, Antonio Beteta, deputy minister for public administration, told reporters. The plan will be presented at a meeting of regional budget chiefs on July 12, he said. “The mechanism aims to make issues more liquid and easier to place on the markets as they have a central-government guarantee,” Beteta said. Regions face redemptions of about 15 billion euros in the second half of the year, according to data on the Budget Ministry’s website.
Spain Says European Rescue for Banks Opens Door to ECB Funding
(Bloomberg) Spain’s FROB rescue fund will distribute bonds issued by the EFSF to the banks, which “can use them at the ECB if they need the liquidity,” Spanish Economy Minister Luis de Guindos told reporters. As part of the agreement for Spain’s 100 billion-euro bank bailout, one or several vehicles will be created to buy assets from lenders at a “reasonable” price, de Guindos said. Those vehicles will issue bonds that will also be eligible at the ECB. Industrywide conditions for the financial assistance include a 9 percent capital requirement, de Guindos said. A first tranche of 30 billion euros is to be used as soon as the end of the month. Remaining details will be clinched in the memorandum of understanding due to be signed on July 20, he said.